- Principal describes the amount of your initial investment made into a particular asset. For example, you may opt to put $1,000 into mutual funds. As a W-2 employee, this $1,000 principal generally represents after-tax money, which was already subject to federal and state income taxes through payroll deductions. Initially, mutual fund principal does not carry any further tax ramifications than would be applicable to any other investment.
- For mutual funds, the tax situation is complicated because individual fund shares represent claims to large asset pools. As a mutual fund investor, you are responsible for paying taxes on capital gains distributions. Capital gains distributions identify your share of realized capital gains that are applicable to the whole pool. Because of these distributions, you may still owe capital gains taxes when your investment principal is unchanged, or when you have even suffered losses. This situation would occur if the money manager sells winning stocks within the mutual fund.
- Beyond the capital gains distributions, you may also be responsible for paying taxes on the realized capital gains and investment income that arise directly from your individual mutual fund shares. Investment income refers to the cash dividends that are paid out upon our fund shares. Additionally, realized capital gains occur when you sell mutual fund shares at a profit. As of 2010, your tax rates on mutual fund capital gains and investment income may be as high as 35 percent.
- For mutual funds, it is important that you are not taxed twice on capital gains. To avoid double taxation, you must understand the concept of cost basis, which describes the amount of cash spent to acquire an investment. Be advised that you can generally add capital gains distributions to your cost basis. For example, you may have originally bought into Mutual Fund Z at $50 per share. Later that year, Mutual Fund Z kicks out $5 worth of capital gains distributions to its shareholders. Your cost basis in Mutual Fund Z would then increase to $55 ($50 + $5). If you eventually sell Mutual Fund Z for $80, you will pay taxes on $25 in realized capital gains ($80 - $55 = $25).
- Traditional IRA, Roth IRA and 401k retirement accounts enable you to defer taxes on your mutual funds over the long term. For retirement accounts, tax deferral means that you will not owe taxes on investment income and capital gains as they occur within the account. Be advised that you may be subject to a 10 percent additional penalty tax on retirement plan withdrawals made before age 59 1/2.