How Mutual Fund Investments Are Taxed
Do you invest in mutual funds? Unless you hold your investment in a tax-deferred account, you'll want to consider taxes when you look at a fund's returns. After all, it's not what your fund earns but what you keep that counts.
Distributions of Fund Income
Mutual funds are required to distribute almost all of their income -- including realized capital gains, dividends, and interest -- to their shareholders each year. The tax bite from these distributions reduces the fund's total return to the investor.
Capital gains. The tax rate on long-term capital gains is capped at 15% for most taxpayers, and 20% for those with higher incomes. However, if a fund sells a security at a gain before meeting the more-than-one-year holding period for long-term capital gain treatment, the gain is considered short term and is taxable to you when distributed at your regular tax rate. Regular individual tax rates currently range as high as 37%.
Dividends. The tax rates on qualifying dividends mirror the long-term capital gains rates. These rates apply to qualifying dividends a mutual fund receives on stocks in its portfolio and distributes to shareholders. Dividends that don't qualify for a favorable rate are taxable to you at your regular tax rate.
Interest. Distributions of interest a fund earns on bonds, certificates of deposit, and other interest-bearing investments are generally taxable to you at your regular tax rate. However, interest you receive from a municipal bond fund is generally exempt from federal income taxes (and possibly state taxes as well).
Note that a 3.8% surtax on net investment income may also apply to your capital gains, dividends, and interest from mutual fund investments if your income exceeds a tax law threshold. And you must pay taxes on taxable fund distributions whether or not you reinvest the distributions in additional shares of the fund.
Sales of Fund Shares
When you sell shares in a mutual fund, you'll typically have a gain or loss to report on your tax return. If the securities in the fund's portfolio have gone up in value during the period the fund has owned them, this appreciation is reflected in the share price. Similarly, if the value of the fund's holdings has dropped, the share price will reflect the loss in value.
Your gain or loss on a sale of fund shares is figured by comparing the amount you realize on the sale to your cost basis in the shares you sold. If you sell all the shares you own, figuring your taxes is easy. You just add up all the investments you've made, including reinvested dividends and other distributions, and compare that amount to the net sale proceeds to determine whether you have a gain or loss. However, if you don't sell all your shares at once, you must use an IRS-approved method for figuring your cost basis.
Taxes can have a significant effect on your mutual fund returns. Be sure to consider them in evaluating your investments.