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.
Table of Contents
- Tip #1: Keep Track of Reinvested Dividends
- Tip #2: Be Aware That Exchanges of Shares Are Taxable Events
- Tip #3: Be Wary of Buying Shares Just Before Ex-Dividend Date
- Tip #4: Do Not Overlook the Advantages of Tax-Exempt Funds
- Tip #5: Keep Records of Your Mutual Fund Transactions
- Tip #6: Reinvesting Dividends & Capital Gain Distributions when Calculating
- Tip #7: Adjust Cost Basis for Non-Taxable Distributions
- Tip #8: Use the Best Method of Identifying Sold Shares
- Tip #9: Avoid Backup Withholding
- Tip #10 Don’t Forget State Taxation
- Tip #11: Don’t Overlook Possible Tax Credits For Foreign Income
- Tip #12: Be Careful About Trying the “Wash Sale” Rule
- Tip #13: Choose Tax-Efficient Funds
- How The Various Identification Methods Compare
- Government and Non-Profit Agencies
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.
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 ordinary dividends that are 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 the sale is ordinary income, but capital gain distributions are long-term regardless of the length of time held before the distribution.
In 2021, tax rates on capital gains and dividends remain the same as 2020 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 $40,400 for individuals and $80,800 for married filing jointly. For an individual taxpayer whose income is at or above $445,850 ($501,600 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 $40,400 and below $445,850 for single filers).
In 2021, say your taxable income, apart from long-term capital gains and qualified dividends, is $87,000. Even though you’re in a middle-income tax bracket (22 percent on a joint return in 2021) and you’ll get the benefit of a lower capital gains tax rate, in this case, 15 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.
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 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 Tip No. 5, below) by 65 percent of the gain, representing the gain reduced by the credit.
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: