Wednesday, May 7, 2008


More misconceptions.

While none of my clients asked me this question during this past tax season, every now and then I will hear, “Why am I paying taxes on these dividends? I didn’t receive the money – it was reinvested.”

I have also been asked on various occasions why I reported a capital gain on the transfer of money from one mutual fund to another mutual fund within the same fund “family” (Fidelity, Vanguard, T Rowe Price, Van Kampen, etc).

“I didn’t sell anything – I just moved it to another fund.”

Just because you did not receive cash in your hands does not mean that it is not taxable.

Dividends are taxed when paid by the corporation or mutual fund, regardless of where the money actually went. In the case of reinvested dividends it is as if you received a dividend check, deposited the check, and then purchased additional shares of the fund.

If the Flach Fund issues a $50.00 dividend payable in December 2007, and as per your instructions to the fund all dividends are reinvested, you pay tax on $50.00 on your 2007 income tax return. The $50.00 will increase your cost basis in the fund investment.

When you sell your total investment in the Flach Fund all the dividends that have been reinvested over the years will be added to your original purchase, and any subsequent cash purchases, to determine the cost basis for calculating taxable gain or loss.

You purchased 100 shares of the fund for $1,000.00 in February 2002. You were issued $425.00 in dividends from 2002 through 2007, all of which were reinvested. You sell your entire investment in the fund in 2008 for $2,000.00. You have a $575.00 taxable capital gain, most of which will be “long-term”.

Part or all of the $50.00 dividend that was issued in 2007 by the Flach Fund may be considered “qualified dividends” and taxed not at your “regular” income tax rate, but at the lower capital gains rate of 5% or 15%. That portion of the $50.00 that is “qualified” will be identified on the Form 1099-DIV you receive from the Flach Fund.

In 2008 the lower 5% capital gains rate is reduced to 0% - so if the fund issues another $50.00 dividend in 2008 and you are in the 15% “regular” tax bracket you will pay absolutely no federal income tax on the $50.00, although, as far as I know, it will still increase your cost basis in the fund.

While “qualified” dividends are taxed separately at a lower rate, the dividend income will increase your Adjusted Gross Income (AGI) and may cause you to reduce or lose various deductions and/or credits and/or increase taxable Social Security or Railroad Retirement benefits. So, as discussed here before, the effective tax cost of the $50.00 dividend may be more than 5% or 15%.

When you transfer money between funds of the same “family” (i.e. from Fidelity Growth and Income to Fidelity Puritan) think of it similar to reinvested dividends – you sell shares in Fidelity G+I, receive and deposit a check, and then use the money to purchase shares of Puritan. It is no different than telling your broker to sell shares in GE and use the money to buy shares of IBM. Each individual fund is a separate investment and each transfer is treated as a separate sale of that investment and must be reported on Schedule D. It does not matter that the funds are in the same “family”.

The only exception is if you transfer money from a “money market fund” to a mutual fund. The price of a share in a money market fund is always $1.00. Money market funds are basically the same as cash. If you transfer money from a money market or cash reserves account of a fund family to the family’s Growth and Income Fund it is like taking money out of a savings account at your local bank and using it to purchase shares of the fund. The sale of shares of a money market account does not have to be reported on Schedule D.

Any questions?



Anonymous said...

tax makes investment to be more complex, agree ?

Robert D Flach said...


Taxes make life more complex. That's why there are people like me - who will never be unemployed.