Taxes are always an important consideration when investing. The rules that require mutual funds to distribute earnings and profits to investors can result in a surprising extra tax bill if an investor does not plan ahead. Many investors choose to reinvest fund distributions. However, the investor still owes taxes on those distributions.
Mutual fund distributions will be classified as either capital gains or dividends. The capital gains are further subdivided into short- and long-term gains. A mutual fund is required by law to distribute any portfolio earnings from interest, dividends or securities sold for a profit at least once a year. Investors an choose to receive the different types of distributions as cash payments, or to have distributions reinvested into more shares of the fund. Even if distributions are reinvested, they must be reported on an investor's annual income tax return.
The tax nature of mutual fund dividends is based on the securities held in a mutual fund's portfolio. If a fund owns municipal bonds, interest earned from these bonds is tax-free income. The dividends paid to investors will also be tax-free. Taxable bond funds pass through interest income as fully taxable dividends. Dividends from stock shares might be classified as qualified dividends and taxed at a lower rate. When a fund sends investors a IRS form 1099-DIV, the classification of paid dividends will be allocated as taxable, tax-free or qualified.
A mutual fund incurs a capital gain if a security held in the fund's portfolio is sold for a profit. If a fund has net capital gains for the year, those gains will be distributed to shareholders near the end of the year. The form 1099 from the fund will allocate capital gains between long- and short-term gains. Short-term capital gains are taxed at the fund investor's regular income tax rate. Long-term gains qualify for a lower tax rate. As of August 2011, the tax rates on long-term gains and qualified dividends were the same.
Tax Reporting Considerations
For bond funds and many stock funds, the amount of dividends earned during the year can be accurately estimated by totaling the quarterly or monthly dividend distributions. It is not possible to predict the amount of capital gains distributions a fund will pay, although the fund is more likely to make a large distribution if it has performed well for the year. To estimate your capital gains for the year, obtain the amount of capital gains distributions from the fund's website at the end of the year, and multiply the distribution amount times the number of shares you own.
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