There are plenty of benefits to be had from investing in mutual funds, including professional management of your investment dollars and gaining an immediately diversified portfolio of securities. The Internal Revenue Service also has some unique tax treatments for mutual funds. You might owe capital gains taxes on your mutual fund shares while you own them, and again when you sell them.
The IRS considers just about everything you own, including your stocks and bonds, to be capital assets. When you sell a capital asset for more than your paid for it, you end up with a taxable capital gain, but you don't owe any capital gains tax on that asset until you sell. For example, if you bought stock in XYZ corporation 10 years ago for $10 per share, and today it is worth $100 per share, you don't owe any taxes on the appreciated value of that stock. Mutual fund shares are also capital assets, but they operate under a different set of rules.
Mutual Fund Shares
A mutual fund is a shared portfolio of securities. When you own a share of a mutual fund, you own a piece of every security in the fund's portfolio. When the fund manager sells a security in the fund's portfolio, the gain or loss is shared by all of the fund's shareholders. The mutual fund must pass any gains that are not offset by losses to shareholders by the end of their accounting year in the form of a distribution.
Short-Term Vs. Long-Term
Capital gains in a mutual fund can be either long-term or short-term, depending on how long the fund has held the security. The portion of the fund's net capital gains that comes from short-term gains is passed through to shareholders as a taxable dividend. The portion that comes from long-term gains is passed through as a long-term capital gains distribution. You get to use the more advantageous long-term capital gains rate for your capital gains distributions regardless of how long you have owned shares of the mutual fund.
Sale of Fund Shares
You might also incur a capital gain or loss when you sell your mutual fund shares. The normal holding period applies to the sale of your mutual fund shares. If you owned the shares for more than one year, any gain is taxed as a long-term capital gain. If you owned the shares for one year or less, any gain is taxed at your ordinary income tax rate.