Distributions from a mutual fund consist of ordinary dividends and capital gains distributions. With the exception of tax-exempt mutual funds, dividends and distributions received from mutual funds are taxable. Like most investments, their taxability largely depends on how the proceeds are distributed.
Ordinary Dividends
An ordinary dividend is a distribution of currently taxable earnings (including short-term capital gains) and is treated as dividend income on your tax return. Certain dividends are identified as "qualified dividends" based on the source of the dividend. Qualified dividends are taxed at a lower tax rate through 2012.
The short-term capital gains distributed from the mutual fund cannot offset capital losses realized from other investments. Most states do not tax the portion of fund dividends attributed to interest from federal obligations. The amount is passed through to shareholders as a percentage of their dividends. In addition, states generally do not tax obligations issued by that state and/or its municipalities. Check with the fund at year-end for the anticipated percentage of income attributable to federal obligations, as well as those issued by your state and/or its municipalities.
Capital Gains Distributions
Capital gains distributions are paid from long-term capital gains realized by the mutual fund, and should be reported by you as long-term capital gains on Schedule D (Form 1040), regardless of how long you have owned shares in the mutual fund. Consider selling investments trading at a loss to offset some or all of the capital gains distributions.
Long-term capital gains distributed by the fund are taxable at the appropriate capital gains rate of 15%
(or 0% for those in the 15% or lower tax bracket). Although this is the same rate applied to most ordinary dividends through 2012, unlike dividends, these distributions can be net against losses.
If you wish to take advantage of the lower long-term capital gains tax rates and netting opportunities, you may consider investing in growth-oriented mutual funds with low turnover. Mutual funds that hold assets longer may make capital gains distributions subject to the lower long-term capital gains tax rate. You may also wish to consider tax-efficient or tax-managed mutual funds, which are specifically managed to minimize taxable distributions and maximize long-term growth within the fund.
Other Distributions
A fund may make a distribution that is greater than its earnings and profits. This type of distribution is considered a return of your investment capital and is not taxable. The information is reported on Form 1099-DIV and should appear on your tax return as a nontaxable distribution, which reduces your basis in the fund accordingly.
To the extent that a return of capital distribution exceeds your basis in the shares, the excess is treated as either a long-term or short-term capital gain, depending on your holding period of the mutual fund.
Corporate shareholders may qualify for a 70% "dividend received deduction" on dividends the fund receives from investing in U.S. corporations. The fund will notify its shareholders about the percentage of the dividends qualifying for the dividend received deduction. This rule does not apply to Subchapter S corporations.
Mutual funds that invest in foreign stocks and securities may elect to pass through the foreign taxes paid on the securities to you if the fund meets certain requirements. If the mutual fund elects to do this, the foreign taxes may be added to the dividends paid and you will be allowed to take a tax credit or a deduction of the taxes paid against your U.S. tax liability. Neither the foreign tax deduction nor credit applies to investments held in a tax-deferred account.
Sale, Redemption, or Exchange of Fund Shares
As with individual stocks, the sale or redemption of mutual fund shares generate taxable gain or loss for the shareholder. The sale or exchange is taxable even if the fund invested in tax-exempt obligations.
Cost Basis
If you sold, redeemed, or exchanged fund shares during the past year, you will need to figure out the gain or loss from the transaction for income tax purposes. This is done by comparing your cost basis in the shares sold to the selling price.
There are several ways to determine your cost basis. You can use the cost paid for each separate investment lot and/or reinvestment lot, or you may elect an average cost-basis method. Once you select a method for a particular mutual fund, you cannot change that method. However, you are entitled to use a different cost-basis method for each mutual fund you purchase.
Your choice of method for determining cost is important, since the most tax-efficient method chosen, according to your circumstances, may significantly reduce the tax impact on your sale of shares, if or when you choose to "lighten up" your holdings in a particular mutual fund.
Selecting Which Shares to Sell
You may have multiple shares in a mutual fund that you acquired over time by direct purchases and/or by dividend reinvestment programs. Some of these shares may be held short-term and some may be held long-term. In addition, if your cost basis is determined by using the price paid for each share, each lot has a different cost basis. The ability to identify which shares are sold may present a tax-planning opportunity. If you do not adequately identify which lot is sold, the first-in, first-out method (FIFO) is used. However, under the specific identification method, any shares that are specifically identified can be designated as the ones sold. However, specific identification is not available if you determine your cost basis using the average cost-single category method.