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 … Read the rest of this article!