Taxes on distributions from a mutual fund held in a traditional individual retirement account (IRA) will be deferred until you withdraw money from the fund. But the tax benefits you get now may cost you later. When investing, it's important to know the tax benefits, or consequences, involved.
Mutual funds consist of a collection of securities -- usually stocks and bonds. When you buy a mutual fund share, you're essentially acquiring a portion of the value of the assets in the fund. When those assets are sold at a level higher than their purchase price or when the securities pay interest or a dividend, that money is distributed equally among all shareholders.
Kinds of Distributions
Mutual funds typically make three kinds of distributions: dividends, long-term capital gains and short-term capital gains. In a taxable account, long-term capital gains distribution and the portion of any distribution from qualifying dividends are taxed at the rate reserved for those two types of income -- 15 percent for 2011. Short-term capital gains and non-qualifying dividends -- including income from bonds -- are taxed as ordinary income. In an IRA account, none of that matters as taxes on every kind of distribution are deferred.
Timing of distributions
Mutual funds distribute income on a regular schedule, such as every year, twice a year, quarterly or monthly. It's not uncommon for a fund to distribute dividends quarterly and capital gains at the end of the year.
Paying the Taxes
When you withdraw money from your IRA, there is no distinction made on the different mutual fund distributions you have received. Every withdrawal is taxed as ordinary income. So if your marginal tax rate is higher than 15 percent in retirement, you will pay more tax on a long-term capital gain distribution from a mutual fund than if you had held it in a taxable account.
Distributions from mutual funds holding municipal bonds issued by local governments or their agencies are exempt from federal tax -- unless those mutual funds are housed in an IRA. Tax-free mutual fund distributions are considered ordinary income when you take them out of your IRA account. Because tax-free funds typically have lower yields than funds holding taxable assets of a similar class, there is no reason to hold a tax-free fund in an IRA.
Distributions from mutual funds holding non-U.S. securities are sometimes reduced to satisfy tax requirements of a foreign country. In a taxable account, you can recover the withheld amount by filing for a foreign tax credit. Distribution income lost through foreign taxes in a mutual fund distribution within an IRA cannot be recovered.
Master limited partnerships (MLPs) and royalty trusts often generate dividends labeled as unrelated business taxable income (UBTI). If that income is more than $1,000, you might have to pay tax on it immediately, even if it is held in an IRA. However, mutual funds and exchange-traded funds are allowed to effectively remove the UBTI and the immediate tax liability. You still must pay ordinary income tax on your IRA withdrawal, but using mutual funds allows you to reap the often-juicy yields of MLPs and royalty trusts without immediate tax consequences.