How Mutual Funds Are Taxed

Similar to partnerships, mutual funds pay no taxes themselves and operate on a pass-through basis (technically, the IRS puts mutual funds in the category of “regulated investment companies”). For tax purposes, the mutual fund distributes investment income to the fundholders, and depending upon the classification of the income, the fundholder will then pay taxes on the income received.

Generally, a mutual fund makes one of the following six types of investment distributions to its fundholders: (1) a return of capital distribution; (2) short-term capital gains; (3) long-term capital gains; (4) qualified dividends; (5) unqualified dividends; and (6) tax-exempt interest dividends.

A return of capital is a return of some funds that you initially invested. If you handed someone $100, and then they gave you $5, there would just be a readjustment as though you only contributed $95. The $5 that you receive back is not a taxable event, but modifies the cost basis to adjust for what you actually contribute.

A short-term capital gains distribution is the receipt of investment income from the sale of a stock that has been in the fund for less than a year. It is important to note that this is from the fund manager’s perspective, not yours as a fundholder. The measurement would be whether the fund manager sold shares of, say, Wells Fargo stock in under twelve months, not whether you owned the fund itself for twelve months. The tax rate for short-term capital gains range from 10% to 39.6%.

A long-term capital gain distribution means that the fundholder has received investment income from the sale of a stock that had been held in the fund for more than a year. Again, this has nothing to do with how long you specifically have held the fund. If you bought the fund in August, but the fund manager sells some Colgate-Palmolive stock that he bought in September 2014, the investment income distribution that you receive will be taxed as a long-term capital gain. This rate caps out at 23.8%.

A qualified dividend just means a cash distribution that comes from a corporation to the fund and then the fund gives it to the fundholder, and the long-term capital gain rate applies. Under the current U.S. structure, this means that a maximum rate of 23.8% applies. If it is a corporation domiciled outside the United States, you may need to pay another tax in place of or in addition to the qualified dividend rate.

An unqualified dividend is a dividend that is a payout from a real estate investment trust, a master limited partnership, a dividend from a money market account, or a dividend paid on a stock option from your employer.

A tax-exempt interest dividend only applies when you invest in a fund that maintains over 50% of its investment in tax-exempt securities throughout the year. Tax-exempt interest dividends do not count towards the fundholder’s gross income, except for performing calculations for the alternative minimum tax. If it is a private municipal bond, separate rules may apply.

What if you reinvest investment income from any of these sources? Then, something called “constructive receipt of investment income” is applied. This just means that whatever amount is reinvested, it is taxed as though you received the income as much. If the activity occurs within a tax-advantaged account like a traditional IRA, then no tax applies until the funds are withdrawn.