What’s ordinarily thought of as double taxation of dividends is this: You own a company. It makes a profit. That profit is taxed once to the corporation, and then a second time when you receive it as a dividend. (Corporations have been prety aggressive in getting around this by finding ways to pay little or no corporate income tax, and by paying out little or no dividends. Many buy back their own stock instead, which in theory will give the value of your stock — and, especially, the value of management’s options — a little lift.)

But there’s another double taxation of dividends that’s inadvertent and entirely avoidable. I referred to it last week.

Lynn Smith: “You say: ‘I’m also assuming you are not accidentally double-counting as taxable gains appreciation from reinvested dividends. You’ve already paid tax on that portion of the growth in the value of your holdings. This is a common mistake.’

“I don’t consider myself a novice, but I’m not following your comment about double-counting. I’m taxed on it when I receive a dividend. The fact that I choose to reinvest that dividend income or just invest the same amount of regular old money has no bearing on whether its appreciation will be taxed. Both would be taxed equally when sold. What am I missing?”

Say you put $10,000 into a fund and check “reinvest dividends.” Now 5 years later, it’s $20,000. This is just great, and congratulations.

You sell.

Some people make the mistake of entering $10,000 as their cost, $20,000 as their proceeds, and pay tax on the $10,000 profit.

You, of course, have added to that original $10,000 cost the additional cost of all those additional shares you purchased by reinvesting your dividends — and on which you paid income tax each year.

Let’s say you got and reinvested $3,000 in dividends and capital gains over the five years. Where some might accidentally show $10,000 as their cost, $20,000 as their proceeds, and pay tax on the $10,000 profit, you show a cost of $13,000 and pay tax on only the actual $7,000 previously-untaxed profit. The folks who declare a $10,000 gain are paying tax on the previously taxed $3,000 TWICE.

Robert Doucette: “How do I figure out how much I would owe in Capital Gains from a mutual fund investment? I know how much was paid originally and how it is worth now, but every year we pay taxes on the funds in our taxable accounts? Surely we are paying the Capital gains on the installment plan?!?”

Same deal. If you’ve been reinvesting the dividend/gains distributions, you have to keep track of them (or get the fund to send you a recap). Add all your reinvested dividends to your cost for the original shares, so you get a total of all you’ve paid for the original, plus the additional, shares.

On the other hand, if you’ve been getting actual checks — and using them to pay the rent rather than reinvesting them — any gain in your account is taxable. It’s a gain on your original shares, which is all you have. If you paid $10,000 and sell for $17,000, that’s a $7,000 gain, plain and simple.

Yes, if the fund distributed lots of dividends and capital gains each year, you did pay a lot of tax along the way. But whenever it paid cash out, it also lowered its net asset value per share.

Shares you bought at $10 that rose $4 in net asset value to $14 and then paid out a $4 capital gains distribution are instantly, after the pay-out, back to $10. If you sell, there is no gain.

Indeed, while it’s not always a great idea to buy shares in a fund just before a large capital gains distribution is paid, it’s not quite the disaster people warn of, either. Say you paid $14 Tuesday and the next day, Wednesday, you got a $4 taxable distribution. Well, if this is going to cause you a problem, just sell the shares — now instantly $10 a share after distributing the $4 — and you will have a $4-a-share loss to net out the $4-a-share gain. (Of course, if this were a load fund, or a fund with a surrender charge, you couldn’t be so cavalier about it.)

Have I just left you more confused? Well then, enough mutual funds for a day or two.

Tomorrow: A Broken Clock That’s Right All Day

 

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