A mutual fund distributes its profits to investors that purchase shares in the fund. Earnings may come from increases in stock held by the fund or the sale of fund investments. The taxes you must pay for your portion of distributions can depend on the amount of earnings you receive, the type of fund in which you invest or your personal tax bracket. Certain mutual funds may offer tax benefits from both federal and state governments.
Your mutual fund may include securities that offer regular dividend payments, such as annual payments on stock earnings. In the majority of cases, the Internal Revenue Service (IRS) requires mutual-fund investors to pay taxes on dividend distributions they receive. The amount of taxes you must pay for dividend distributions can vary. If you can report the earnings as dividend income, you may qualify for special tax treatment and pay a rate no higher than 15 percent, according to Wells Fargo. However, dividends reported as regular income may qualify as a personal short-term capital gain, which may be taxable at a higher rate. Even if you choose to invest your dividend distributions back into the fund, you typically face the same tax liability.
If you sell your shares of a mutual fund, you typically must pay capital-gains taxes on any earnings you make. Personal capital-gains taxes can vary, depending on how long you kept your mutual-fund investment before the sale. You may also face capital-gains taxes when a fund manager sells part of a fund and the transaction leads to earnings for the fund itself. In such cases, fund managers may treat a portion of distribution payments as a capital gain. Choosing to reinvest distributions received from fund capital gains may not eliminate or decrease your tax liability.
Funds With Lower Tax Liability
Certain types of funds feature lower tax liability than others. Municipal bond funds may offer a lower tax liability than other types of funds. Funds that invest in municipal bonds often receive certain federal tax exemptions. If you purchase shares of a fund that backs debt within your state of residency, and your state requires you to pay income taxes, you may also be exempt from paying state dividend taxes. You may also consider low-turnover funds, which minimize selling and buying transactions. Low-turnover funds typically have lower capital gains, which can minimize your tax liability.
The time of year you buy into a mutual fund can determine whether you earn or lose money during the first year. Mutual funds often distribute capital gains at the end of the calendar year. You must pay taxes on capital gains earned by the fund, which may lead to a loss if you purchase shares near the distribution date. For example, if you purchase shares of a poorly performing fund in December, your tax liability may be higher the amount of dividend you receive. However, if you purchase shares toward the end of the year and the fund pays a high year-end dividend, you may see a profit.
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