The way your mutual fund investment is treated for tax purposes has a lot to do with the type of investments within the fund's portfolio. In general, most distributions you receive from a mutual fund must be declared as investment income on your yearly taxes. However, the type of distribution received, the duration of the investment holding and the type of investment are all important factors in determining how much income tax you pay on each dollar of a distribution. In some cases, distributions are subject to your ordinary income tax rate, which is the highest rate, but in other cases, you may be eligible to pay the lower capital gains tax rate. Still, other distributions may be completely tax-free.

Ordinary Income Vs. Capital Gains

The difference between ordinary income and capital gains income can make a huge difference to your tax bill. In short, only investment income you derive from investments held for a year or more is considered capital gains. This concept is pretty straightforward when it comes to investing in individual stocks. The world of mutual funds, however, is a little more complicated.

Mutual funds are simply investment firms that invest the collective contributions of their thousands of shareholders in numerous securities called portfolios. When it comes to distributions, the difference between ordinary income and capital gains has nothing to do with how long you have owned shares in a mutual fund, but rather how long that fund has held an individual investment within its portfolio.

If you receive a distribution from a fund that results from the sale of a security the fund held for only six months, that distribution is taxed at your ordinary income tax rate. If the fund held the security for several years, however, then those funds are subject to the capital gains tax instead. When a mutual fund distributes long-term capital gains, it reports the gains on Form 1099-DIV, Dividends and Distributions, and issues the form to you before tax time.

Why Is This Important?

The difference between your ordinary income tax rate and your corresponding capital gains tax rate can be quite large, so it is important to keep track of which income is subject to the lower rate. For 2015, those in the 10 and 15% income tax brackets are not required to pay any income tax on long-term capital gains. Individuals in the 25 to 35% tax brackets must pay only 15% tax on capital gains. Those in the highest income tax bracket of 36.9% are subject to a 20% capital gains tax.

Selling Mutual Fund Shares: Figuring Your Gains and Losses

If you sell your shares in a mutual fund, any amount of the proceeds that is a return of your original investment is not taxable since you already paid income taxes on those dollars when you earned them. Therefore, it is important to know how to calculate the amount of your distribution attributed to gains rather than investments.

To determine how much of your investment income is gain or loss, you must first know how much you paid for the shares that were liquidated, called the basis. Because mutual fund shares are often bought at various times, in various amounts and at various prices, it is sometimes difficult to determine how much you paid for a given share. There are two ways the IRS allows taxpayers to determine the basis of their investment income: cost basis and average basis.

If you know the price you paid for the shares you sold, then you can use the specific share identification cost basis method. However, if you own many shares that have been purchased at different times, this method may be very time-consuming. Alternatively, you can use the first-in-first-out cost basis method, in which you use the price of the first share purchased as the basis for the first share sold and so forth.

If you cannot determine the price you paid for specific shares, you may choose to use the average basis method, where you can use the aggregate cost of all your shares as the cost basis for each share sold. However, all your mutual fund shares must be identical to employ this method, meaning you cannot use the average basis method to figure your gains if some of your shares are part of a dividend-reinvestment plan and some are not.

Like income from the sale of any other investment, if you have owned the mutual fund shares for a year or more, any profit or loss generated by the sale of those shares is taxed as capital gains. Otherwise, it is considered ordinary income.

Dividend Distributions

In addition to distributing income generated by the sale of assets, mutual funds also make dividend distributions when underlying assets pay dividends or interest. This most often occurs when a fund holds dividend-bearing stocks or bonds, which typically pay a regular amount of interest annually, called a coupon. In general, dividend income is taxed as ordinary income. However, there are two very important exceptions.

Qualified Dividends

Dividend distributions received from your mutual fund may be subject to the capital gains tax if they are considered qualified dividends by the IRS. To be qualified, the dividend must be paid by a stock issued by a U.S. or qualified foreign corporation. In addition, your mutual fund must have held the stock for at least 60 days within the 121-day period beginning 60 days prior to the ex-dividend date. The ex-dividend date is the date after which the owners of newly purchased stock are ineligible for the dividend payment. If the ex-dividend date is April 12, for example, any investors who purchase stock on or after this date do not receive the impending dividend.

This complicated requirement is meant to discourage investors from purchasing dividend-bearing stocks right before payments and then selling them off again. Essentially, this means your fund must have owned the stock in question for either 60 days prior to the ex-dividend date or a combination of days before and after that date that total at least 60 days. If your fund distributes qualified dividends, these dividends are reported to you on Form 1099- DIV.

Tax-Free Interest

The other way to minimize your income tax bill is to invest in so-called tax-free mutual funds. These funds invest in government and municipal bonds, called munis, that pay tax-free interest. Money market mutual funds, for example, invest primarily in short-term government bonds and are widely considered stable and safe investments.

However, while municipal bonds pay interest that is exempt from federal income tax, it may not be exempt from your state or local income taxes. In some cases, interest paid on bonds issued by governments in your state or residence may be triple-tax-free, meaning the bonds are exempt from all income tax. However, verify with your fund which bonds within its portfolio are tax-free and to what degree in order to avoid being blindsided by unexpected taxation.

The taxation of mutual fund income and distributions can be extremely complex. Unless you own just a handful of shares and keep careful records, it may behoove you to consult a tax professional to ensure you are properly reporting all your investment income.

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.