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Exchanges between mutual funds can have significant tax ramifications in some cases. Failure to take the rules for how these transactions are taxed into account can lead to a nasty surprise come tax time. Knowing which funds you can exchange without tax consequences can drastically reduce your tax bill and make managing your finances easier.

Mutual Fund Exchange
When you exchange shares of one mutual fund for another, the fund company must liquidate the shares of the fund that you currently own and use the dollar proceeds to purchase shares of the fund into which you are transferring. Thus, a sale and purchase takes place.

Taxation of Exchanges
A taxable gain or loss must be computed on the shares of the fund that are sold. If you held the shares of the fund for less than a year, then it will be a short-term gain or loss. If you held them longer, then it will be a long-term gain or loss. This gain or loss is in addition to the annual gains or losses that the fund distributes to all of its shareholders at the end of each year. These rules apply to all mutual fund exchanges that take place in taxable retail accounts.

Retirement Plan Exchanges
Exchanges that are done entirely within any kind of retirement plan or IRA are not reportable. No tax is paid on any gain realized or loss deducted from any loss realized. This is true regardless of the type of amount of fund shares that are exchanged. However, funds inside retirement plans cannot be exchanged directly into any type of taxable account; the sale proceeds must be taken out as a fully taxable distribution first (or a nontaxable distribution if it is coming from a Roth IRA).

Variable Annuity Subaccount Mutual Funds
Exchanges from variable sub-account funds inside variable annuities are also nontaxable. Sales and purchases that take place inside the annuity contract are non-reportable in the same manner as IRAs and other retirement plans, regardless of whether the annuity contract is housed inside a tax-deferred account or not. The same goes if you move your money from one variable annuity carrier to another via a tax-free 1035 exchange.

Tax Reporting
You will receive a form 1099-B from the fund company that details any taxable gain or loss that you must report from the sale of the shares of your current fund. If you exchanged funds inside a variable annuity or retirement plan or IRA of any kind, then you will not receive this form.