In the United States, investments in mutual funds may significantly impact the individual income taxes paid by the investor. Mutual funds generate multiple sources of taxable income that must be recognized by individuals on Internal Revenue Service (IRS) Form 1040, U.S. Individual Income Tax Return.
Dividends are cash distributions from companies to equity holders. Dividends are periodically made (usually quarterly) by many large publicly traded companies, although there is no requirement for companies to issue dividends and a number of companies do not issue any dividends at all. Dividend distributions to mutual funds are allocated to the individual investors, who are required to recognize taxable income on the dividends in the tax year during which they are received by the mutual fund. This means that the individual investor may recognize the income from the distribution even though no cash was paid from the mutual fund to the investor.
Most dividends are taxed at the investor’s tax rate for ordinary income -- the same rate paid upon salary or wages. Certain dividends, known as qualified dividends, will qualify for specialized tax treatment at a reduced rate. Dividends are considered qualified if the company’s stock was held by the mutual fund company for more than 60 days in the 121 day period beginning 60 days before the ex-dividend date. (The ex-dividend date is the first day after a company declares a dividend that the holder of stock would no longer receive the next dividend payment.) When mutual fund companies receive a qualified dividend, they report the nature of the dividend to the investor, who may qualify to pay tax at the special, reduced rate. Investors, however, will not qualify for the special rate if they have not themselves held the mutual fund investment for at least 61 days.
Capital Gain Distributions
Mutual funds are constantly buying and selling the underlying investments held in the mutual fund. For example, a stock mutual fund will buy and sell shares of stocks and a bond fund will buy and sell bonds. When the stocks, bonds, and other capital assets held within a mutual fund are sold, capital gains or losses are generated. In general, a capital gain is generated when the capital assets are sold for an amount greater than the cost of the assets and a capital loss is generated when the capital assets are sold for an amount less than the cost of the assets. Investors must recognize capital gains and losses whenever the mutual fund sells underlying capital assets. These transactions are reported to investors at the end of each year as capital gain or loss distributions.
Tax Exempt Funds
Some mutual funds promote themselves as tax exempt funds. Typically, this means that the mutual funds will invest in state, local and federal bonds. As most state and local bond interest is exempt from federal taxation, the mutual fund investor will not need to pay federal tax on the interest generated from these funds. Often, however, the investor will still be liable for state and local taxes. In addition, the investor must pay both federal and state taxes on any capital gains generated by the mutual fund.
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