How are distributions from mutual funds taxed? What happens when they are reinvested? How are capital gains
on sales of mutual funds determined? This Financial Guide provides you with tips on reducing the tax on
mutual fund activities.
A basic knowledge of mutual fund taxation and careful record-keeping can help you cut the tax bite on your
mutual fund investments.
You must generally report as income any mutual fund distributions, whether or not they are reinvested. The
tax law generally treats mutual fund shareholders as if they directly owned a proportionate share of the
fund's portfolio of securities. Thus, all dividends and interest from securities in the portfolio, as well
as any capital gains from the sales of securities, are taxed to the shareholders.
The fund itself is not taxed on its income if certain tests are met and substantially all of its income
is distributed to its shareholders.
Taxable Distributions
There are two types of taxable distributions: (1) ordinary dividends and (2) capital gain
distributions:
Ordinary Dividends. Distributions of ordinary dividends, which come from the interest
and dividends earned by securities in the fund's portfolio, represent the net earnings of the fund. They
are paid out periodically to shareholders. Like the return on any other investment, mutual fund dividend
payments decline or rise from year to year, depending on the income earned by the fund in accordance
with its investment policy. These dividend payments are considered ordinary income and must be reported
on your tax return.
Qualified dividends. Qualified dividends are the ordinary dividends subject to the
same tax rates that apply to net long-term capital gains. Dividends from mutual funds qualify where a
mutual fund is receiving qualified dividends and distributing the required proportions thereof.
Dividends from foreign corporations are qualified where their stock or ADRs are traded on U.S. exchanges
or with IRS approval where the dividends are covered by U.S. tax treaties.
- Capital gain distributions. When gains from the fund's sales of securities exceed
losses, they are distributed to shareholders. As with ordinary dividends, these capital gain distributions
vary in amount from year to year. They are treated as long-term capital gain, regardless of how long you
have owned your fund shares. A mutual fund owner may also have capital gains from selling mutual fund
shares.
Capital gains rates. The beneficial long-term capital gains rates on sales of mutual fund
shares apply only to profits on shares held more than a year before sale. (Profit on shares held a year or
less before sale is ordinary income, but capital gain distributions are long-term regardless of the length
of time held before the distribution.)
In 2019, tax rates on capital gains and dividends remain the same as 2018 rates (0%, 15%, and a top rate of
20%); however threshold amounts are different in that they don't correspond to new tax bracket structure as
they did in the past. The maximum zero percent rate amounts are $39,375 for individuals and $78,750 for
married filing jointly. For an individual taxpayer whose income is at or above $434,550 ($488,850 married
filing jointly), the rate for both capital gains and dividends is capped at 20 percent. All other taxpayers
fall into the 15 percent rate amount (i.e., above $39,375 and below $434,550 for single filers).
In 2019, say your taxable income, apart from long-term capital gains and qualified dividends, is $77,000.
Even though you're in a middle income tax bracket (22 percent on a joint return in 2019) and you'll get
the benefit of the lower capital gains rate, in this case, 0 percent for long-term gains and qualified
dividends.
For tax years 2013-2017 dividend income that fell in the highest tax bracket (39.6%) was taxed at 20
percent. For the middle tax brackets (25-35%) the dividend tax rate was 15 percent, and for the two lower
ordinary income tax brackets of 10% and 15%, the dividend tax rate was zero.
The "qualified five-year capital gains" on stock, in which special rules apply to the gains on the sale of
capital assets held for more than five years, expired at the end of 2012 and was permanently repealed by the
American Taxpayer Relief Act (ATRA) of 2012.
At tax time, your mutual fund will send you a Form 1099-DIV, which tells you what earnings to report on
your income tax return, and how much of it is qualified dividends. Because tax rates on qualified dividends
are the same as for capital gains distributions and long-term gains on sales, Congress wants these items
combined in your tax reporting, that is, qualified dividends added to long-term capital gains. Also, capital
losses are netted against capital gains before applying the favorable capital gains rates. Losses will not
be netted against dividends.
Undistributed capital gains. Mutual funds sometimes retain a part of their capital gain and pay
tax on them. You must report your share of such gains and can claim a credit for the tax paid. The mutual
fund will report these amounts to you on Form 2439. You increase your shares' "cost basis" (more about this
in
Keep Records of Your Mutual Fund Transactions
, below) by 65 percent of the gain, representing the gain reduced by the credit.
Medicare Tax. Starting with tax year 2013, an additional Medicare tax of 3.8 percent is
applied to net investment income for individuals with modified adjusted gross income above $200,000 (single
filers) and $250,000 (joint filers).
Now that you have a better understanding of how mutual funds are taxed, here are 13 tips for minimizing the
tax on your mutual fund activities.
Keep Track of Reinvested Dividends
Most funds offer you the option of having dividend and capital gain distributions automatically reinvested
in the fund--a good way to buy new shares and expand your holdings. While most shareholders take advantage
of this service, it is not a way to avoid being taxed. Reinvested ordinary dividends are still taxed (at
long-term capital gains rates if qualified), just as if you had received them in cash. Similarly, reinvested
capital gain distributions are taxed as long-term capital gain.
If you reinvest, add the amount reinvested to the "cost basis" of your account, i.e., the amount you paid
for your shares. The cost basis of your new shares purchased through automatic reinvesting is easily seen
from your fund account statements. This information is important later on when you sell shares (more about
that in
Keep Records of Your Mutual Fund Transactions
).
Be Aware That Exchanges of Shares Are Taxable Events
The "exchange privilege," or the ability to exchange shares of one fund for shares of another, is a popular
feature of many mutual fund "families," i.e., fund organizations that offer a variety of funds. For tax
purposes, exchanges are treated as if you had sold your shares in one fund and used the cash to purchase
shares in another fund. In other words, you must report any capital gain from the exchange on your return.
The same tax rules used for calculating gains and losses when you redeem shares apply when you exchange
them.
Gains on these redemptions and exchanges are taxable whether the fund invests in taxable or tax-exempt
securities.
Be Wary of Buying Shares Just Before Ex-Dividend Date
Tax law requires that mutual funds distribute at least 98 percent of their ordinary and capital gain income
annually. Thus, many funds make disproportionately large distributions in December. The date on which a
fund's shareholders become entitled to future payment of a distribution is referred to as the ex-dividend
date. On that date, the fund's net asset value (NAV) is reduced on a per share basis by the exact amount of
the distribution. Buying mutual fund shares just before this date can trigger an unexpected tax.
You buy 1,000 shares of Fund XYZ at $10 a share. A few days later, the fund goes ex-dividend, entitling
you to a $1 per share distribution. Because $1 of your $10 NAV is being distributed to you, the value of
your 1,000 shares is reduced to $9,000. As with any fund distribution, you may receive the $1,000 in cash
or reinvest it and receive additional shares. In either case, you must pay tax on the distribution.
If you reinvest the $1,000, the distribution has the appearance of a wash in your account since the value
of your fund investment remains $10,000. The $1,000 reinvestment results in the acquisition of 111.1 new
shares with a $9 NAV and increases the cost basis of your total investment to $11,000. If you were to redeem
your shares for $10,000 (their current value), you would realize a $1,000 capital loss.
In spite of these tax consequences, in some instances it may be a good idea to buy shares right before the
fund goes ex-dividend. For instance, the distribution could be relatively small, with only minor tax
consequences. Or the market could be moving up, with share prices expected to be higher after the
ex-dividend date.
To find out a fund's ex-dividend date call the fund directly.
If you regularly check the mutual fund quotes in your daily newspaper and notice a decline in NAV from
the previous day, the explanation may be that the fund has just gone ex-dividend. Newspapers generally use
a footnote to indicate when a fund goes ex-dividend.
Do Not Overlook the Advantages of Tax-Exempt Funds
If you are in the higher tax brackets and are seeing your investment profits taxed away, then there is a
good alternative to consider: tax-exempt mutual funds. Distributions from such funds that are attributable
to interest from state and municipal bonds are exempt from federal income tax (although they may be subject
to state tax).
The same is true of distributions from tax-exempt money market funds. These funds also invest in municipal
bonds, but only in those that are short-term or close to maturity, the aim being to reduce the fluctuation
in NAV that occurs in long-term funds.
Many taxpayers can ease their tax bite by investing in municipal bond funds. The catch with municipal bond
funds is that they offer lower yields than comparable taxable bonds. For example, if a U.S. Treasury bond
yields 2.8 percent, then a quality municipal bond of the same maturity might yield 2.45 percent. If an
investor is in a higher tax bracket, the tax advantage makes it worthwhile to invest in the lower-yielding
tax-exempt fund. Whether the tax advantage actually benefits a particular investor depends on that
investor's tax bracket.
To figure out how much you would have to earn on a taxable investment to equal the yield on a tax-exempt
investment, use this formula: Tax-exempt yield divided by (1 minus your tax bracket) = equivalent yield of a
taxable investment.
You are planning for the 32% bracket. The yield of a tax-exempt investment is 2.8 percent. Applying the
formula, we get .028 divided by .68 (1 minus .32) = .041. Therefore, 4.1 percent is the yield you would
need from a taxable investment to match the tax-exempt yield of 2.8 percent.
In limited cases based on the types of bonds involved, part of the income earned by tax-exempt funds may
be subject to the federal alternative minimum tax.
Although income from tax-exempt funds is federally tax-exempt, you must still report on your tax return the
amount of tax-exempt income you received during the year. This is an information-reporting requirement only
and does not convert tax-exempt earnings into taxable income.
Your tax-exempt mutual fund will send you a statement summarizing its distributions for the past year and
explaining how to handle tax-exempt dividends on a state-by-state basis.
Capital gain distributions paid by municipal bond funds (unlike distributions of interest) are not free
from federal tax. Most states also tax these capital gain distributions.
Keep Records of Your Mutual Fund Transactions
It is very important to keep the statements from each mutual fund you own, especially the year-end
statement.
By law, mutual funds must send you a record of every transaction in your account, including reinvestments
and exchanges of shares. The statement shows the date, amount, and number of full and fractional shares
bought or sold. These transactions are also contained in the year-end statement.
In addition, you will receive a year-end Form 1099-B, which reports the sale of fund shares, for any
non-IRA mutual fund account in which you sold shares during the year.
Why is record keeping so important? When you sell mutual fund shares, you will realize a capital gain or
loss in the year the shares are sold. You must pay tax on any capital gain arising from the sale, just as
you would from a sale of individual securities. (Losses may be used to offset other gains in the current
year and deducted up to an additional $3,000 of ordinary income. Remaining loss may be carried for
comparable treatment in later years.)
The amount of the gain or loss is determined by the difference between the cost basis of the shares
(generally the original purchase price) and the sale price. Thus, in order to figure the gain or loss on a
sale of shares, it is essential to know the cost basis. If you have kept your statements, you will be able
to figure this out.
In 2012, you purchased 100 shares of Fund JKL at $10 a share for a total purchase price of $1,000. Your
cost basis for each share is $10 (what you paid for the shares). Any fees or commissions paid at the time
of purchase are included in the basis, so since you paid an up-front commission of two percent, or $20, on
the purchase, your cost basis for each share is $10.20 ($1,020 divided by 100). Let's say you sell your
Fund JKL shares this year for $1,500. Assume there are no adjustments to your $ 1,020 basis, such as basis
attributable to shares purchased through reinvestment (for an example of the effect of reinvestment on the
cost basis, see Tip #6.). On this year's income tax return, you report a capital gain of $480 ($1,500
minus $1,020).
Since they are taken into account in your cost basis, commissions or brokerage fees are not deductible
separately as investment expenses on your tax return.
One of the advantages of mutual fund investing is that the fund provides you with all of the records that
you need to compute gains and losses--a real plus at tax time. Some funds even provide cost basis
information or compute gains and losses for shares sold. That is why it is important to save the statements.
However, you are not required to use the fund's gain or loss computations in your tax reporting.
Re-investing Dividends & Capital Gain Distributions when Calculating
Make sure that you do not pay any unnecessary capital gain taxes on the sale of mutual fund shares because
you forgot about reinvested amounts. When you reinvest dividends and capital gain distributions to buy more
shares, you should add the cost of those shares (that is, the amount invested) to the cost basis of the
shares in that account because you have already paid tax on those shares. Failure to include reinvested
dividends and capital gain distributions in your cost basis is a costly mistake.
You bought 500 shares in Fund PQR 15 years ago for $10,000. Over the years, you reinvested dividends and
capital gain distributions in the amount of $8,000, for which you received 100 additional shares. This
year, you sell all 600 of those shares for $40,000. If you forget to include the price paid for the 100
shares purchased through reinvestment (even though the fund sent you a statement recording the shares you
received in each transaction), you will unwittingly report on your tax return a capital gain of $30,000
($40,000 - $ 10,000) on your redemption of 600 shares, rather than the correct capital gain of 22,000
($40,000 - [$10,000 + $8,000]).
Adjust Cost Basis for Non-Taxable Distributions
Sometimes mutual funds make distributions to shareholders that are not attributable to the fund's earnings.
These are nontaxable distributions, also known as returns of capital. Because a return of capital is a
return of part of your investment, it is not taxable. Your mutual fund will show any return of capital on
Form 1099-DIV in the box for nontaxable distributions.
If you receive a return-of-capital distribution, your basis in the shares is reduced by the amount of the
return.
Fifteen years ago, you purchased 1,000 shares of Fund ABC at $10 a share. The following year you received
a $1-per-share return-of-capital distribution, which reduced your basis in those shares by $1, to give you
an adjusted basis of $9 per share. This year you sell your 1,000 shares for $15 a share. Assuming no other
transactions during this period, you would have a capital gain this year of $6 a share ($15 - $9) for a
total reported capital gain of $6,000.
Nontaxable distributions cannot reduce your basis below zero. If you receive returns of capital that, taken
together, exceed your original basis, you must
report the excess as a long-term capital gain.
Your overall basis will not change if non-taxable distributions are reinvested. However, your
per-share basis will be reduced.
Use the Best Method of Identifying Sold Shares
Calculating the capital gain or loss on shares you sell is somewhat more complicated if, as is usually the
case, you are selling only some of your shares. You then must use some accounting method to identify which
shares were sold to determine your capital gain or loss. The IRS recognizes several methods of identifying
the shares sold:
- First-in, first-out (FIFO),
- Average cost (single category and double category), and
- Specific identification.
Reports from your funds may include a computation of gain or loss on your sale of mutual fund shares.
Typically, these will use the average cost method, single category rule. This is done as a convenience. You
are allowed to adopt one of the other methods.
First-In, First-Out (FIFO)
Under this method, the first shares bought are considered the first shares sold. Unless you specify that
you are using one of the other methods, the IRS will assume you are using FIFO.
Average Cost
This approach allows you to calculate an average cost for each share by adding up the total cost of all the
shares you own in a particular mutual fund and dividing by the number of shares. If you elect to take an
average cost approach, you must then choose whether to use a single-category method or a double-category
method.
-
With the single-category method, you simply group all shares together, add up the cost, and
divide by the number of shares. Under this method, you are deemed to have sold first the shares you have
held the longest.
-
The double-category method enables you to separate short-term and long-term shares. Shares held
for one year or less are considered short-term; shares held for more than one year are considered
long-term. You average the cost of shares in each category separately. In this way, you may specify
whether you are redeeming long-term or short-term shares.
Keep in mind that once you elect to use either average cost method, you must continue to use it for all
transactions in that fund unless you receive IRS approval to change your method.
Specific Identification
Under this method, you specify the individual shares that are sold. If you have kept track of the purchase
prices and dates of all your fund shares, including shares purchased with reinvested distributions, you will
be able to identify, for example, those shares with the highest purchase prices and indicate that they are
the shares you are selling. This strategy gives you the smallest capital gain and could save you a
significant amount on your taxes.
To take advantage of this method, you must, at the time of the sale or exchange, indicate to your broker or
to the mutual fund itself the particular shares you are selling. The IRS also insists that you receive
written confirmation of your instructions.
To see the advantages and disadvantages of these methods of identifying sold shares, see How The
Various Identification Methods Compare (below).
Money market funds present a very simple case when you redeem shares. Because most money market funds
maintain a stable net asset value of $1 per share, you have no capital gain or loss when you sell shares.
Thus, you only pay tax on any earnings distributed.
Avoid Backup Withholding
One way the IRS makes sure it receives taxes owed by taxpayers is through backup withholding. In the mutual
fund context, this means that a mutual fund company is required to deduct and withhold a specified
percentage (see below) of your dividend and redemption proceeds if one of the following situations has
occurred:
-
You have not supplied your taxpayer identification number (Social Security number) to the fund
company;
- You supplied a TIN that the IRS finds to be wrong;
- The IRS finds you have underreported your interest and dividend payments; or
- You failed to tell the fund company you are not subject to backup withholding.
The backup withholding percentage is 24 percent for tax years 2018-2025 (28 percent in prior years).
Don't Forget State Taxation
Many states treat mutual fund distributions the same way the federal government does. There are, however,
some differences. For example:
-
If your mutual fund invests in U.S. government obligations, states generally exempt from state taxation
dividends attributable to federal obligation interest.
-
Most states do not tax income from their own obligations, whether held directly or through mutual funds.
On the other hand, the majority of states do tax income from the obligations of other states. Thus, in
most states, you will not pay state tax to the extent you receive, through the fund, income from
obligations issued by your state or its municipalities.
- Most states don't grant reduced rates for capital gains or dividends.
Don't Overlook Possible Tax Credits for Foreign Income
If your fund invests in foreign stocks or bonds, part of the income it distributes may have been subject to
foreign tax withholding. If so, you may be entitled to a tax deduction or credit for your pro-rata share of
taxes paid. Your fund will provide you with the necessary information.
Because a tax credit provides a dollar-for-dollar offset against your tax bill, while a deduction reduces
the amount of income on which you must pay tax, it is generally advantageous to claim the foreign tax
credit. If the foreign tax doesn't exceed $300 ($600 on a joint return), then you may not need to file IRS
form 1116 to claim the credit.
Be Careful About Trying the "Wash Sale" Rule
If you sell fund shares at a loss (so you can take a capital loss on your return) and then repurchase
shares in the same fund shortly thereafter, beware of the wash sale rule. This rule bars a loss deduction
when a taxpayer buys "substantially identical" shares within 30 days before or after the date of sale.
Be sure to wait more than thirty (30) days before reinvesting.
Choose Tax-Efficient Funds
Many investors who hold mutual funds directly may hold others through tax-sheltered accounts such as
401(k)s, IRAs, and Keoghs. Your aggressive high-turnover funds and high-income funds should be in
tax-sheltered accounts. These generate more current income and gains, currently taxable if held directly but
tax-deferred in tax-sheltered accounts. Buy-to-hold funds and low activity funds such as index funds should
be owned directly (as opposed to a tax-sheltered account). With relatively small currently distributable
income, such investments can continue to grow with only a modest reduction for current taxes.
For some investors, the simpler approach may be to hold mutual funds personally and more highly taxed
income (such as bond interest) in the tax-sheltered account.
As you can see, there are many tax pitfalls that await the unwary mutual fund investor. Professional
guidance should be considered to minimize the tax impact.
How The Various Identification Methods Compare.
To illustrate the advantages and disadvantages of the various methods of identifying the shares that you
sell, assume that you bought 100 shares of Fund PQR in January 2005 at $20 a share, 100 shares in January
2006 at $30 a share, and 100 shares in November 2010 at $46 a share. You sell 50 shares in June of this year
for $50 a share. Here are your alternative ways to determine cost basis.
- First-In, First-Out (FIFO).The FIFO method identifies the 50 shares sold as
among the first 100 shares purchased. Your cost basis per share is $20. This rate gives you a capital gain
of $1,500 ($2,500 - (50 x $20)).
- Advantages/Disadvantages. In this example, this method produces the highest
amount of capital gain on which you are taxed. FIFO provides the lowest capital gain amount when the
fund's net asset value has declined and the first shares purchased were the most expensive. It can also
sometimes save tax when shares bought later weren't held long enough to qualify for long-term capital
gains treatment.
- Average Cost/Single Category. Average cost/single category allows you to
calculate the average price paid for all shares in the fund. Here, your cost basis per share is $32 (your
300 shares cost $9,600: $9,600 divided by 300 = $32), giving you a capital gain of $900 ($2,500 - (50 x
$32)).
- Advantages/Disadvantages.: Compared to FIFO, this method can reduce the amount
of your capital gain if the fund's net asset value has increased over time. You could generate a lower
long-term capital gain by using specific identification, but average cost/single category is useful if you
did not designate shares at the time of sale or you simply do not want to do the record keeping required
to use the specific identification method.
- Average Cost/Double Category. Under this method, you average the cost of the
short-term shares (those held for one year or less) and the cost of the long-term shares (those held for
more than one year) separately. Thus, in the long-term category, you have 200 shares at $5,000 for an
average cost of $25 per share ($5,000 x 200), and in the short-term category, you have 100 shares at
$4,600 for an average cost of $46 per share ($4,600 divided by 100). Comparing the two categories, your
taxable gain using the long-term shares would be $1,250 ($2,500 - (50 x $25)), to be taxed at up to 20
percent, while your taxable gain using the short-term shares would be $200 ($2,500 - (50 x $46)), to be
taxed at up to 37 percent (top rate for 2019).
- Advantages/Disadvantages. In this example, using the average cost of the
short-term shares produces a better result. However, because of the current spread between the top
marginal income tax rates and the maximum rate on long-term capital gains, it could make sense in some
instances to choose the long-term shares. Furthermore, as with specific identification, you must plan
ahead to use this method by specifying to the broker or mutual fund company at the time of sale that you
are selling short-term or long-term shares, and you must receive confirmation of your specification in
writing. If you have elected to use average cost-double category but do not specify for a particular
redemption whether you are redeeming short-term or long-term shares, the IRS will deem you to have
redeemed the long-term shares first.
- Specific identification. With this method, you designate which shares you are
selling. To reduce your capital gains tax bill the most, you would select the shares with the highest
purchase price. In this case, you would identify the 50 shares sold as among those purchased in 1999. Your
cost basis, therefore, is $46 per share, giving you a capital gain of $200 ($2,500 - (50 x $46)).
- Advantages/Disadvantages: This method can produce favorable results in lowering
the capital gain, but IRS regulations require you to think ahead by providing instructions before the sale
and then receiving confirmation of your specification in writing. The IRS will not let you designate
shares after the fact.
Government and Non-Profit Agencies
Securities and Exchange
Commission
100 F Street, NE
Washington, D.C. 20549
(202) 942-8088
website
The SEC has public reference rooms at its headquarters in Washington, D.C., and at its Northeast and
Midwest Regional offices. Copies of the text of documents filed in these reference rooms may be obtained
by visiting or writing the Public Reference Room (at a standard per page reproduction rate) or through
private contractors (who charge for research and/or reproduction).
Other sources of information filed with the SEC include public or law libraries, securities firms,
financial service bureaus, computerized on-line services, and the companies themselves.
Most companies whose stock is traded over the counter or on a stock exchange must file "full disclosure"
reports on a regular basis with the SEC. The annual report (Form 10-K) is the most comprehensive of these.
It contains a narrative description and statistical information on the company's business, operations,
properties, parents, and subsidiaries; its management, including their compensation and ownership of
company securities: and significant legal proceedings which involve the company. Form 10-K also contains
the audited financial statements of the company (including a balance sheet, an income statement, and a
statement of cash flow) and provides management's discussion of business operations and prospects for the
future.
Quarterly financial information on Form 8-K may be required as well.
Anyone may search the SEC's
Company Filings database for information regarding to including quarterly and annual reports,
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