Series 65: Taxation Of Mutual Funds

Taxation of Mutual Funds

Mutual funds, which are essentially large pools of investments that individual investors buy a slice of, generally pay out a combination of capital gains, interest income, and dividend income each year. Here are some important general pieces of information to remember about mutual funds distributions.

• • First, a mutual fund will specify how much of each type of earnings (short-term gains, long-term gains, dividends, etc.) each investor received, even if those amounts are immediately reinvested in the mutual fund.
• • Second, investors are responsible for paying taxes on all types of earnings. They will pay short-term capital gains taxes if the fund holds the securities for one year or less.
• • Third, all investors receive the same amount per share if they are owners at the time of distribution (which is offset by a drop in their share price), even if they have not experienced the gains in their own account. This can lead to what is known as “phantom gains,” where an investor is forced to pay tax on gains without having actually earned any in their account.

Mutual Fund Distributions

Mutual fund companies do not pay taxes as long as they pass on their income and capital gains to the shareholders of the fund. The shareholders have to pay taxes on the income earned from any dividends paid from securities and any interest earned on bonds within the fund. They also have to pay taxes on any capital gains distributions incurred when the fund sold stocks or bonds at a profit.

• • Interest on bonds is taxed at the investor’s ordinary income rate.
• • Dividends are taxed at either the qualified rate or the investor’s ordinary income rate, depending on the dividend.
• • Capital gains distributions are taxed at the short-term capital gains rate if the fund held the security one year or less. The short-term capital gains rate is the investor’s ordinary tax rate.
• • Capital gains distri