As a mutual fund shareholder, you have an ownership stake in a portfolio of different securities. Many of the securities within a fund portfolio generate interest or dividends and these payments are passed onto shareholders in the form of mutual fund dividends. You also make a profit known as a capital gain if you sell a mutual fund for a profit. If the fund generates a profit by selling securities, then those earnings are also passed onto shareholders as dividends. You normally have to pay tax on both your capital gains and your dividend income, although some funds generate tax-exempt income.
When you sell mutual fund shares for a profit, you have to pay capital gains tax. You also pay this tax on taxable distributions derived from the profit’s the fund generated by selling securities. Gains on shares that you have held for one year or less are classified as short-term gains and are subject to ordinary income tax rates. Gains on shares you have held for longer than one year are classified as long-term gains and are subject to the 15 percent capital gains tax. Ordinary income tax rates range from 15 to 35 percent, which means that many people pay more taxes on their short-term gains than there long-term gains. You also pay ordinary income tax on dividend payments that consist of interest payments on the underlying securities.
If you sell some of the shares that you hold in a particular fund, the IRS assumes that you sold the shares you bought first, because the IRS uses first-in-first-out as the default taxation method for share redemptions. However, you can opt to use the specific identification method in which case you identify the shares that you sold. This can make a difference if you bought shares for different prices on different dates, as you can minimize your tax burden by selling the shares that experienced the lowest growth. Many investors also use the average cost method, which involves calculating the average cost per share and paying taxes by calculating your capital gains on a per share basis.
You may have to pay capital gains tax even if your investment loses money. If the fund manager buys some shares inexpensively and then later sells those shares for profit, then the fund generates a capital gain that passes along to investors. Even if the fund portfolio loses money, you still have to pay taxes on the capital gains distribution.
If you hold your shares inside a 401k or another type of tax-deferred account, you do not have to pay taxes on your income or gains until you make withdrawals. When you do withdraw cash from a tax-deferred account you pay ordinary income tax rather than capital gains tax regardless of how long you held the shares. Some mutual funds contain municipal bonds and interest payments on these bonds are generally exempt from federal income tax. Therefore, you pay no taxes on distributions derived from bond interest payments, although you do have to pay taxes on capital gains you make when you sell your shares.
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