Avoid Surprises Related to Mutual Fund Distributions

Like individual stocks, investors are required to pay on gains realized from mutual fund holdings. However, the process of identifying mutual fund gains and calculating how much is owed on those gains is much less straightforward than the process for individual stocks. Understanding the types of mutual fund distributions, how they are taxed, and the importance of timing is crucial when helping clients purchase and sell mutual fund holdings.

Most mutual funds make distributions based on earnings and other payouts at the end of the year. Distributions are based on net amounts, calculated as capital gains and other earnings less expenses for running the funds.[1]

Shareholders are required to report mutual funds transactions on their taxes annually and pay any taxes owed. Mutual fund shareholders could possibly owe taxes in these circumstances:

  • The shareholder sells shares and a gain is realized on the transaction.
  • The fund sells shares and a gain is realized on the transaction.
  • The shareholder moves between mutual funds at the same company and a gain is realized.[2]

All taxable events are reported to shareholders via IRS Form 1099-DIV, which are sent out after January 1 for the prior calendar year. The shareholder’s tax rates are determined by the type of distribution made, how long the investment was held, and the type of investment. The following chart outlines how mutual fund distributions may be taxed:[3]

Distribution Type

Description Capital Gains Rate Ordinary Income Rate

Non-Taxable

Long-term capital gains Shares held more than one year

X

Short-term capital gains Shares held less than one year

X

Qualified dividends Dividends from common stock of domestic corporations or qualifying foreign corporations

X
*

Ordinary or non-qualified dividends Interest and non-qualified dividends minus expenses

X
Tax-exempt interest Interest on certain bonds designated as tax-exempt

X
**

Taxable interest Interest on fixed-income securities

X

Federal interest Interest on federal debt instruments

X
***

Required distributions Non-investment income required to be distributed by the fund

X

Return of capital Portion of invested capital returned to shareholder

X

*Subject to certain restrictions
**Not taxable for federal taxes; may be taxable at state or local level
***Exempt from state income tax

 

Timing is important when it comes to purchasing mutual fund shares. Fund distributions apply to all shareholders, whether they held the share for one day or 365 days during the calendar year.[4] If a share is purchased on December 31 and a distribution is made on January 6, the shareholder could end up owing taxes on the distribution immediately after purchase. This is known as “buying-the-dividend” and could significantly impact the investor’s tax liability.[5]

Timing is also a factor when selling shares. Market price is usually lower following a distribution and selling shares after a distribution is made may yield less gain and generate a lower tax bill.[6] To find out when mutual funds are scheduled to make distributions, visit the fund’s home page and search for “year end distributions.” The site should provide information regarding distribution dates, helpful information to have when creating annual action plans with clients.

 

This content is provided for informational purposes only, it is not intended to provide specific legal or tax advice and should not be construed as advice designed to meet the needs of an individual’s situation. Information and opinions obtained from third party sources are believed to be reliable but cannot be guaranteed by AEWM.

685002 For investment professional use only not for use with a consumer or in a sales situation.

 

[1] Claire Boyte-White. Investopedia. Dec. 15, 2017. “Income tax on mutual funds: The basics.” https://www.investopedia.com/articles/investing/091715/basics-income-tax-mutual-funds.asp  Accessed Nov. 28, 2018.

[2] Brian Beers. Investopedia. Feb. 1, 2018. “Why not just buy before the dividend, then sell?” https://www.investopedia.com/ask/answers/buy-before-dividend-then-sell/  Accessed Nov. 29, 2018.

[3] Claire Boyte-White. Investopedia. Dec. 15, 2017. “Income tax on mutual funds: The basics.” https://www.investopedia.com/articles/investing/091715/basics-income-tax-mutual-funds.asp  Accessed Nov. 28, 2018.

[4] Fidelity. “Mutual Funds and Taxes.” https://www.fidelity.com/tax-information/tax-topics/mutual-funds  Accessed Nov. 28, 2018.

[5] Ibid.

[6] Ibid.

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