Investing & Taxes
Capital Gain and Income Distributions
Mutual funds must distribute at least 98% of their annual income to investors for the funds to avoid taxation. Funds may distribute four types of income, based on their investments.
Long-Term Capital Gain Distributions
When a mutual fund makes a profit from the sale of investments in its portfolio, it generally passes the profit on to you in the form of capital gains. Long-term capital gains are gains on securities owned by the fund for more than one year.
Ordinary Income Distributions
A mutual fund earns dividends, interest and other investment income on the securities in which it invests. After a fund subtracts its expenses from the investment income, it distributes the remainder to you as an ordinary income distribution.
The IRS requires that ordinary income distributions include any short-term capital gains (gains on securities owned by the fund for one year or less) realized and distributed by the fund.
Qualified Dividend Distributions
A special category called "qualified dividends" applies to dividends paid on stock investments. The mutual fund will pass through to investors any qualified dividends it receives from stocks in the fund's portfolio. Short-term capital gain amounts may also be categorized as qualified dividends.
Tax-Exempt Dividend Distributions
Interest from state and local municipal bonds is exempt from federal taxes and generally is exempt from state taxes in the state in which the bonds were issued. Mutual funds that invest in these securities generally distribute tax-exempt dividends to their investors.
Return of Capital Distributions
A return of capital distribution is not considered income, rather it is a return of your original investment dollars and is nontaxable.
How You Are Taxed
Distributions generally are subject to federal income taxes and may be subject to state and local taxes, whether you reinvest them or take them in cash. The tax status of a capital gain distribution is determined by how long the mutual fund held the underlying security that was sold, not by how long you have been invested in the fund.
Long-Term Capital Gains:
Your tax bracket determines how much tax you will owe on long-term capital gain distributions, as shown in the table below.
Ordinary Income Distributions:
This category also includes short-term capital gains. You will owe tax on these distributions at the rate of your ordinary income tax bracket.
Qualified Dividend Distributions:
Qualified dividends are taxed at the long-term capital gain rates, as shown in the table below.* They may also include short-term capital gains. To qualify for these reduced rates, you must own the mutual fund shares for a period of 61 days or longer. That period must include the date the fund distributed the dividends.
Tax-Exempt Dividend Distributions:
While the dividends may be tax exempt, a portion of the income may be an adjusting item for the Alternative Minimum Tax. It also is possible to have taxable capital gains from investing in tax-exempt bond funds since bond prices fluctuate in response to changing interest rates. By selling bonds at a profit, a fund can generate capital gain distributions that may be subject to federal and state income taxes.
Return of Capital:
Because this type of distribution is a return of your original investment dollars it is nontaxable. Your cost basis should be reduced by the same amount as the distribution.
Taxation of Capital Gains and Qualified Dividends*
|Income Tax Bracket||Long-Term Capital Gains and Qualified Dividend Rates|
* As part of the American Taxpayer Relief Act of 2012, long-term capital gains rates are now permanent. The five-year capital gain rate that was effective prior to 2001 was repealed. Qualified Dividend income is now permanent, and will be taxed at the long-term capital gain rates.
** Taxpayers with a MAGI over $250,000 (joint) or $200,000 (single) will have the additional 3.8% surtax on investment type income (net investment income, including interest, dividends and capital gains). Learn more.
This information is for educational purposes only and is not intended as tax advice. Please consult your tax advisor for more detailed information or for advice regarding your individual situation.