The Basics of Determining Taxes on Mutual Funds

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The Basics of Determining Taxes on Mutual Funds

Many investors have issues about the best approach to compute their mutual fund taxes. The tax treatment of your mutual fund is heavily influenced by the investments in the fund’s portfolio.

In general, most mutual fund dividends must be reported as investment income on your annual tax return. However, the kind of distribution received, the period of the investment holding, and the type of investment all have a role in deciding how much income tax you pay on each dollar of distribution.

Distributions may be subject to your regular income tax rate, which is the highest rate in certain situations. In certain situations, you may be able to pay a reduced capital gains tax rate. Other types of payouts may be entirely tax-free.

Key Takeaways

  • Mutual funds that generate a large number of short-term capital gains and are taxed at ordinary income (rather than capital gains) rates might cost you money.
  • When it comes to payouts, the difference between ordinary income and capital gains is determined by how long a fund has held a certain investment in its portfolio.
  • If you receive a distribution from a fund as a consequence of the sale of a security held by the fund for less than six months, the distribution is taxed at your regular income tax rate.
  • However, if the fund kept the asset for many years, it is liable to capital gains tax instead.

Ordinary Income vs.Capital Gains

The distinction between regular income and capital gains income may have a significant impact on your tax burden. To summarize, only investment income from assets held for more than a year is considered capital gains.

When it comes to investing in particular equities, this notion is rather easy. However, the world of mutual funds is a bit more convoluted.

Mutual funds are investment businesses that invest the combined contributions of thousands of owners in a variety of assets known as portfolios. When it comes to dividends, the distinction between ordinary income and capital gains has nothing to do with how long you’ve had mutual fund shares, but rather how long the fund has held an individual investment within its portfolio.

If you receive a distribution from a fund as a consequence of the sale of a security held by the fund for less than a year, the distribution is taxed at your regular income tax rate. However, if the fund held the asset for 12 months or longer, it is liable to capital gains tax instead. When a mutual fund distributes long-term capital gains, the gains are reported on Document 1099-DIV, Dividends and Distributions, and the form is sent to you before the annual tax filing deadline.

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Why Is This Important?

The difference between your regular income tax rate and your long-term capital gains tax rate might be significant. This is why it is critical to keep track of whose income qualifies for the lower rate.

Long-term capital gains are not subject to income tax in 2022 for people in the 10% and 12% tax categories. Individuals in the 22%, 24%, 32%, 35%, and a portion of the 37% tax categories (up to $445,850 in 2022) are subject to a 15% capital gains tax. Additionally, persons in the highest tax rate of 37% who earn more than the limit are liable to a 20% capital gains tax.

Figuring Your Gains and Losses

If you sell your mutual fund shares, any portion of the earnings that constitutes a return on your initial investment is not taxable since you previously paid income taxes on those dollars when you received them. As a result, it is critical to understand how to compute the portion of your payout that is attributable to gains rather than investments.

To establish how much of your investment income is gain or loss, you must first know how much you paid for the liquidated shares. This is known as the foundation. Because mutual fund shares are often purchased at different periods, in different numbers, and at different prices, it may be difficult to ascertain how much you spent for a specific share.

Cost Basis and Average Basis

The Internal Revenue Service (IRS) permits taxpayers to establish the basis of their investment income in two ways: cost basis and average basis.

You may use the particular share identification cost basis approach if you know the amount you paid for the shares you sold. However, if you possess a large number of shares acquired at separate dates, this strategy may be time-consuming. You may also utilize the first-in, first-out cost basis technique, in which the price of the first share acquired serves as the foundation for the first share sold, and so on.

If you are unable to establish the price you paid for particular shares, you may utilize the average basis approach, which allows you to use the total cost of all your shares as the cost basis for each share sold. However, to use this approach, all of your mutual fund shares must be equal, which means you cannot use the average basis method to calculate your profits if some of your shares are part of a dividend reinvestment plan (DRIP) and some are not.

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If you have held the mutual fund shares for a year or longer, any profit or loss created by the sale of those shares is taxed as long-term capital gains, just like any other investment income. Otherwise, it is treated as regular revenue.

Dividend Distributions

Mutual funds make dividend payments when underlying assets produce profits or interest, in addition to distributing money gained by asset sales. Mutual funds are pass-through investments, which implies that any earnings must be transferred to shareholders. This is most common when a fund invests in dividend-paying stocks or bonds, which normally pay a fixed amount of interest yearly, known as a coupon.

When a corporation declares a dividend, it also publishes the ex-dividend and record dates. The date of record is the day on which the corporation checks its list of shareholders who will be paid dividends. Because there is a time lag while trading stocks, any sale of shares that happens less than three days before the date of record is not recorded, and the selling investor’s name remains on the list of shareholders. The ex-dividend date is the date before the record date.

How Are Dividend Distributions Taxed?

Dividend income is often taxed like regular income. If your mutual fund often buys and sells dividend equities, any dividends you earn will almost certainly be taxed as regular income. Assume you get $1,000 in dividend payments from your actively managed fund. If you are in the 24% tax rate, you will pay $240 in taxes.

There are two significant exceptions: qualifying dividends and tax-free interest.

Qualified Dividends

Dividend payments from your mutual fund may be liable to capital gains tax if the IRS considers them qualifying dividends. The dividend must be paid by shares issued by a U.S. or eligible foreign firm to be qualified. In addition, your mutual fund must have held the stock for at least 60 days during the 121-day period commencing 60 days before the ex-dividend date.

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The ex-dividend date is the date after which newly bought stock owners are no longer eligible for dividend payments. If the ex-dividend date is April 12, for example, investors who buy shares on or after that day will not get the next dividend.

This may seem complicated, but it just means that the fund must possess the stock for at least 60 days before the ex-dividend date, or a combination of days before and after, totaling at least 60 days. This onerous condition is intended to deter investors from buying funds with dividend-paying companies soon before payments and then selling them again simply to earn the payout. If your fund pays out eligible dividends, they are reported to you on Form 1099-DIV.

Tax-Free Interest

Another option for lowering your tax payment is to invest in so-called tax-free mutual funds. These funds invest on tax-free government and municipal bonds, generally known as “munis.” Money market mutual funds, for example, are typically regarded as secure and safe investments since they invest predominantly in short-term government bonds.

However, although municipal bonds pay interest that is tax-free in the United States, they may not be tax-free in your state or municipality. Interest paid on bonds issued by governments in your state of residency may be triple-tax-free in certain situations, which means the bonds are exempt from all income taxes. To prevent being caught off guard by unanticipated taxes, check with your fund to see which bonds in its portfolio are tax-free and to what extent.

The Bottom Line

Even for the most seasoned investor, calculating the taxes owed on mutual fund income and dividends may be quite complicated. The IRS publication 550, Investment Income and Expenses (Including Capital Gains and Losses), might help you understand these difficulties. However, unless you own just a few shares and maintain meticulous records, you may benefit from seeing a tax specialist to verify that all of your investment income is correctly reported.

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