The Box, the Bag, and the Wrapper Analogy: Mutual Fund Investing
“You need to open a retirement account so you can take the deduction on your tax return.”
“Do you have a 1099-DIV for the dividends you were paid on the IBM stock?”
Did you hear these comments during tax season?
Completing your tax return is tough enough- then tax preparers and investment advisors throw in these other questions.
Mutual funds can be particularly confusing.
What investments are in my mutual fund? Do I have to pay taxes each year? If I sell the fund, what is the tax impact?
To clear up these issues, I’ll use the The Box, the Bag, and the Wrapper Analogy.
Your Amazon shipment
Ok, let’s assume that you get a box from Amazon. Inside the box are 10 bags, and each bag contains individually wrapped pieces of candy.
Got it?
The Box: The Type of Investment Account
The box is the type of brokerage account that you use the purchase the mutual fund. Generally speaking, there are two types:
Taxable account: The interest on bonds, dividends on stock, and capital gains or losses are reported on your tax return each year.
Retirement account: The most common retirement account is a 401(k) account through your employer, and you can set up other types of retirement accounts if you’re self-employed. The tax impact of interest, dividends, and capital gains and losses is deferred. There is no tax impact until you withdraw funds at retirement.
401(k) retirement accounts include contributions from your employer that are not taxed until retirement. Other retirement plans tax the contributions before you invest.
The Bag: The Mutual Fund
Inside the box (the account) may be one or more mutual fund investments. For example, Washington Mutual is a fund that invests in U.S. equities (common stock).
To diversify investment risk, your account may be different types of mutual funds, including stock funds, bond funds, and balanced funds that invest in both stocks and bonds.
The Wrappers: The Fund Investments
A bag (mutual fund) may own dozens — or hundreds — of individual stocks and bonds (candy wrappers).
Washington Mutual owns dozens of stocks in a variety of industries. As of this writing, the fund owns shares in 188 different stocks.
Clearing up tax confusion
If your box is a taxable account, you can expect to receive tax documents that report interest income, dividend income, and possibly capital gains and losses each year. If the box is a retirement account, the tax impact is deferred until you sell the investment.
If your mutual fund buys and sells stocks in a taxable account, there will be a tax impact. Stock or bond sales in a retirement plan do not impact your taxes until you withdraw funds.
Food for thought.