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When you invest in a mutual fund, the fund you own may pay distributions to your account. You will owe tax on these distributions in the year they are received unless you own the fund shares in a tax-deferred account, such as an IRA or 401(k).
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 DistributionsWhen 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 DistributionsA 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 DistributionsA 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.
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.
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.
*Lowered rates for qualified dividends and capital gains are a result of the 2003 Tax Act and have been extended through December 31, 2012, as part of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010.
Here are a few tips that may help you minimize your taxes from distributions:
IRS Circular 230 Disclosure: American Century Companies, Inc. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with American Century Companies, Inc. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties.
This information is for educational purposes only and not intended as tax advice. Please consult your tax advisor for more detailed information or for advice regarding your individual situation.