Many investors have questions on the best way to calculate their taxes on mutual funds. The way your mutual fund 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. In other cases, you may be eligible to pay the lower capital gains tax rate. Other distributions may be completely tax-free.
Ordinary Income Versus 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 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 the annual tax filing date.
Why Is This Important?
The difference between your ordinary income tax rate and your corresponding long-term capital gains tax rate can be quite large. This is why it is important to keep track of which income is subject to the lower rate. For 2019, those in the 10% and 12% income tax brackets are not required to pay any income tax on long-term capital gains. Individuals in the 22% to 35% tax brackets must pay 15% tax on capital gains. Those in the highest income tax bracket of 37% are subject to a 20% capital gains tax.
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. This is 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.
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 (DRIP) 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 long-term capital gains. Otherwise, it is considered ordinary income.
In addition to distributing income generated by the sale of assets, mutual funds also make dividend distributions when underlying assets pay earnings or interest. Mutual funds are pass-through investments, which means any income they receive must be distributed to shareholders. 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.
When a company declares a dividend, it also announces the ex-dividend date and date of record. The date of record is the date on which the company reviews its list of shareholders who will receive the dividend payment. Because there is a time delay when trading stocks, any sale of shares that occurs fewer than three days before the date of record is not registered, and the list of shareholders still includes the name of the selling investor. The date three days before the date of record is the ex-dividend date.
How Are Dividend Distributions Taxed?
In general, dividend income is taxed as ordinary income. If your mutual fund buys and sells dividend stocks often, more than likely any dividends you receive are taxed as ordinary income. For example, assume you receive $1,000 in dividend payments from your actively managed fund. If you are in the 24% income tax bracket, you pay $240 at tax time.
However, there are two very important exceptions: qualified dividends and tax-free interest.
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. Also, your mutual fund must have held the stock for more than 60 days within the 121-day period beginning 60 days before 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 may sound confusing, but essentially it means the fund must own the stock for either 60 days before the ex-dividend date or a combination of days before and afterward, adding up to at least 60 days. This complicated requirement is meant to discourage investors from purchasing funds with dividend-bearing stocks right before payments and then selling them off again, just to get the dividend. If your fund distributes qualified dividends, these dividends are reported to you on Form 1099-DIV.
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, also 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, they may not be exempt from your state income tax or local income taxes. In some cases, interest paid on bonds issued by governments in your state of 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 Bottom Line
Calculating the taxes you owe on mutual fund income and distributions can be extremely complex, even for the most seasoned investor. Unless you own just a handful of shares and keep careful records, you may benefit from consulting a tax professional to ensure you are properly reporting all your investment income.