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WASHINGTON — As mutual funds increase in popularity and more employees are compensated with stock options, taxpayers must beware of some pitfalls that can mean a big tax bill from the Internal Revenue Service. 

Mutual funds, for example, sometimes offer to automatically reinvest capital gains and dividends instead of sending the investor a check. But even if the investor never pocketed the cash, this money is treated as income by the IRS and taxed accordingly. 

“You get tagged for the dividends you don’t receive and it’s a gain that you don’t really realize,” said Don Weigandt, vice president for wealth strategy at J.P. Morgan. 

The mutual fund will send a tax form reporting all dividends that were reinvested, which must be reported as income on Schedule B of the 1040 form. The fund’s reinvestments also could have either a capital gain or loss consequence; IRS Publication 564 spells this out and Schedule D must be used to report capital gains and losses. 

Some taxpayers who get into a mutual fund late in the calendar year can also get an unanticipated tax bill, Weigandt said. Since most funds pay out dividends in December, the taxpayer gets a relatively modest share but is taxed on the full value of the capital gain made by the mutual fund that year. 

“If you are buying into a fund, you want to be buying in after that dividend date,” he said. “You should ask, ’Maybe I should wait a while.”’ 

One other mutual fund tip: some investors may qualify for the foreign tax credit if their fund invests in overseas securities. It can be claimed as a deduction or as a credit with IRS Form 1116; a credit is usually worth more because it is a dollar-for-dollar reduction in tax. 

Stock options, or rights to purchase a certain number of shares at a set price, can also raise some sticky tax questions. In some circumstances, taxes are owed even before the options are cashed in – meaning the taxpayer has to come up with the money from some other source. 

The two main types of stock options are nonqualified options and incentive stock options, or ISOs. The main difference is that the taxpayer must report income when exercising a nonqualified option, but not an ISO, because the nonqualified option is treated essentially as a form of salary by the tax code. 

Although an ISO isn’t subject to regular income tax, it could trigger the 28 percent alternative minimum tax. Otherwise, the main tax issue is capital gains, and the taxpayer can take advantage of the lower 20 percent capital gains rates on profits by holding the stock for at least one year after it is exercised and at least two years after it is received, Weigandt said. 

There are numerous variations in stock option plans that can have an impact on taxes, but Weigandt said people must consider all investment factors in making decisions – not just what might be owed to the IRS. “You’ve got to look at it in a broader context,” he said. 

Look for more tax help all this week on the Berkeley Daily Planet’s Business page.