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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.
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.
* 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.
The American Taxpayer Relief Act of 2012 extended or made permanent many of the tax provisions established from previous legislation. Below, we provide a summary of the provisions most relevant to mutual fund investors.
Federal Individual Income Tax Rates
The income tax rate brackets passed in 2001 are now permanent and include a new rate of 39.6%. The income ranges for each bracket will be indexed for inflation going forward.
Alternative Minimum Tax (AMT)
The Alternative Minimum Tax is a parallel tax system that was created to keep high income individuals from avoiding taxes through various deductions and exemptions.
The exemption amounts are increased as shown below and will be indexed for inflation going forward. This provision is retroactive beginning with the 2012 tax year.
Estate, Gift and Generation Skipping Tax Exemptions
Estate assets are taxed at a top rate of 40% with an exemption limit of $5,340,000 for 2014 (based on share price as of the decedent's date of death, including adjustments). This amount will be indexed for inflation going forward.
Tax-Free Charitable Distributions
Distributions from an IRA to a charity may be made tax-free up to $100,000 per taxpayer, per taxable year. The account owner must be age 70½ or older. The legislation extends this provision until the end of 2013 and is retroactive for 2012. Congress has not passed legislation extending this provision for 2014 or beyond.
In addition, the provision contains a transition rule under which an individual can make a rollover during January of 2013 and have it count as a 2012 rollover. Individuals who took a distribution in December of 2012 will be able to contribute that amount to a charity and count it as an eligible charitable rollover to the extent it otherwise meets the requirements for an eligible charitable rollover.
In-Plan Roth Conversions
Participants in 401(k), 403(b) or 457(b) Plans can convert any amount in a non-Roth account to a Roth account if the plan permits. The requirement that an account balance can only be converted to Roth if the amount is otherwise distributable is being eliminated. This is a permanent provision, effective for transfers after December 31, 2012.
Coverdell Education Savings Account (CESA) Limits
The annual contribution limit for CESAs is fixed at $2,000. The contribution deadline for this account type is April 15th of the following year.
No one should pay more income tax than the rules require. But if you don't know all the rules, it's easy to make mistakes that can be costly.
Taxes should never be the only-or even the most important-consideration when investing in mutual funds. You should look for funds that have solid management and good track records and that meet your long-term investment strategy. These features are more likely to help you meet your financial goals, even considering the cost of taxes.
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.