A mutual fund generally does not pay taxes on your behalf, so it's important to monitor your account, and report all taxable distributions when you file your income taxes each year. A mutual fund, (either directly or via your financial advisor) will send you a Form 1099-DIV that summarizes the taxable distributions it made to you during the year (if any).
Taxable distributions include:
- Dividend distributions
Fund portfolios may hold securities that pay dividends. A fund company passes these dividends, minus fund expenses, on to the fund's shareholders. A portion of these dividends may qualify for special tax treatment (maximum rate of 15%) but other portions may not qualify. You may elect to have dividends reinvested to purchase more shares of the fund at the time of the distribution, but reinvesting dividends does not change your tax liability.
Note: Some funds, such as municipal bond funds, invest in municipal debt securities, which may provide income that is exempt from federal income tax and, in some cases, state income tax as well. Before you invest in a municipal bond fund, you should read the prospectus carefully to see if the tax benefits from the fund may be appropriate for your situation. Please keep in mind that you may be subject to state and local taxes as well as the federal alternative minimum tax when owning municipal bond fund shares.
- Capital gains distributions
Mutual funds purchase and sell investments on behalf of the fund's shareholders. When the fund sells investments for a long-term gain, it may treat a portion of its dividend as a capital gain distribution, taxable to you at a maximum rate of 15%. As with dividends, you may generally elect to have capital gains distributions reinvested. And, as with dividends, capital gains distributions you receive from a fund (whether or not you choose to reinvest them) may be taxable.
Capital Gains from the Sale of Mutual Fund Shares
In addition to any capital gains distributions you may receive while you own a mutual fund, you may also sell shares of a fund for a capital gain or a capital loss. You will generally realize a capital gain if you sell your fund shares for more than what you paid for them, taking sales charges into account. This capital gain is taxable.
Short-term gains are subject to ordinary income tax rates, which could be as high as 35% at the federal level. Long-term capital gains are subject to a special 15% federal tax rate; 0% for gains in the 10% or 15% bracket.
To calculate your capital gains, you may choose from one of the tax lot selection methods below or learn more about cost basis reporting.
- First In, First Out (FIFO): This method assumes that the first shares you sold came from the first shares you purchased, so you use the share price from the oldest purchase date.
- Specific Identification Method: This method requires you to "adequately identify" which shares you want to sell by specifying their original purchase date, range of dates purchase price, or range of purchase prices at the time you sell them. You must also retain a written confirmation of the identification from your broker or from the fund company.
- Average Cost Method: With this method, you divide the total cost of all your shares by the total number of shares owned to arrive at an average cost per share. Tax regulations issued in 2010 eliminated a different form of averaging called the double category method.
You can switch back and forth between using the FIFO method and specific identification. You can also elect to use the average cost method after using the FIFO method or specific identification or both. Tax regulations permit you in some situations to revoke (undo) an election to use the averaging method, and you are permitted to switch from the average cost method prospectively at any time. Shares acquired prior to switching from the average cost method continue to have the basis they had immediately before this change, but newly acquired shares will not be averaged unless you once again elect to use averaging for shares of that fund.
Avoid Double Payment
If you automatically reinvest your dividends and capital gains distributions, you should keep all your statements and confirmations for accurate records when it comes time to sell. You have already paid taxes on your reinvested dividends. Your adjusted basis at the time of sale consists of your original investment plus the total amount of reinvested dividends.
This will help to accurately reflect your cost basis and thereby your capital gains tax liability. Investors who do not keep accurate records may end up paying taxes twice on their reinvested dividends — first in the year the dividend is paid and then again when they sell the mutual fund shares.
Mutual funds available without transaction fees may change at any time without notice. Therefore, any mutual funds purchased without a transaction fee may be subject to a transaction fee for subsequent purchases or upon liquidation.