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Mutual fund taxes typically include taxes on dividends and earnings while the investor owns the mutual fund shares, as well as capital gains taxes when the investor sells the mutual fund shares. The tax rate (and in turn the tax on mutual funds) depends on the type of distribution and other factors.
That means you may owe tax on mutual funds you’ve invested in — even if you haven’t sold any of the shares or received any cash from your investments.
Here’s an overview of how and when you pay tax on mutual funds, plus six things you can do to pay less tax.
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When do you owe tax on mutual funds that you own?
Two things can happen while you own your mutual fund that might generate a tax bill. Your mutual fund might pay your share of the dividends or interest that the underlying securities paid during the year. Or, the fund manager might sell some of the securities for-profit and then give you your share of that profit.
A mutual fund combines money from many investors and invests it in assets such as stocks and bonds. Professionals manage the mutual fund and decide when to buy and sell stocks, bonds or other assets in the portfolio. The investors own shares of the mutual fund and pay an annual fee to cover the cost of operating the fund. The value of those shares can rise or fall depending on how the underlying securities in the mutual fund perform.
IRS Publication 550 has the details on the tax rules for investment income and expenses.
1. Tax on mutual funds if you get dividends or interest
Dividends are usually taxable income. When you invest in a mutual fund, you usually get to choose whether you want your share of the dividends distributed to you or automatically reinvested into the mutual fund. If you opt to reinvest your dividends, the IRS generally still considers that money taxable.
Mutual funds that invest in bonds might receive interest payments from those bond investments. Your portion of that interest may also be taxable income, even if you reinvest it. The interest on some bonds, including municipal bonds and U.S. Treasurys, may be tax-free.
If your mutual fund distributes dividends or interest during the year, you’ll probably get an IRS Form 1099-DIV or 1099-INT the following January showing how much you received from the fund. You’ll use the form to report the income on your tax return. Don’t ignore these forms. The sender gives a copy to the IRS, so the IRS is probably going to notice if you don’t report the income.
» MORE: Learn more about how dividends are taxed
2. Tax on mutual funds if the fund managers generate capital gains
If the mutual fund’s managers sell securities in the fund for a profit, the IRS will probably consider your share of that profit a capital gain. Generally, mutual funds distribute these net capital gains to investors once a year.
Capital gains are taxable income, even if you reinvested the money.
You’ll probably get an IRS Form 1099-DIV in January showing your portion of the fund’s capital gains during the previous year. You’ll need this form to report your capital gain on your tax return.
Again, don’t ignore your 1099-DIV; the IRS is going to get a copy, and sooner or later it will probably realize if you don’t report the income.
Your tax on capital gains earned while you still own shares of the mutual fund depends in part on how long the fund held the investments.
» MORE: Learn how capital gains taxes work and what the rates are this year
Tax on mutual funds when you sell
Because a mutual fund invests your money in a variety of assets such as stocks and bonds, the value of your mutual fund’s shares — and your investment — can rise or fall depending on how those underlying securities perform. That can lead to taxes when you sell.
You might sell your mutual fund shares for more than you paid or for more than the cost basis. (That’s usually the goal.) That profit is a capital gain. Capital gains are taxable income.
If you’re like most people and bought your mutual fund shares a little at a time, you probably own a bunch of mutual fund shares that you purchased at various prices.
There are a few different methods for determining exactly which shares you’re selling and how much profit you’re making. In a nutshell, you can specify the exact shares you’re selling, sell the oldest shares first or use the average cost of all the shares you own. The choice is important because it can influence how you calculate your profit and how much tax you might owe.
How long you own your mutual fund shares also matters. If you owned them for more than a year before selling, your capital gains tax rate may be lower.
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6 quick tips to minimize the tax on mutual funds
Wait as long as you can to sell. Selling in less than a year can trigger higher capital gains taxes if you make a profit.
Buy mutual fund shares through your traditional IRA or Roth IRA. If you put money in a traditional IRA, your investments grow tax-deferred; you’re not taxed until you withdraw money. If you put money in a Roth IRA, there are no taxes on investment growth, interest or dividends if you withdraw them after age 59 ½ and have the IRA for at least five years.
Buy mutual fund shares through your 401(k) account. If you put money in a traditional 401(k) account, taxes are deferred until you withdraw the money.
Know what kinds of investments the fund makes. If you don’t want a lot of taxable dividends headed your way every year, for example, then you may not want to invest in a mutual fund that owns a lot of dividend-paying stocks. If you don’t want a lot of taxable capital gains distributions hitting you while you own the shares, then you might favor index funds, which tend to buy and sell their underlying investments infrequently.
Use tax-loss harvesting. If your investments are in a taxable account, you might be able to offset some taxes by selling other underperforming mutual funds or securities at a loss. Those losses can offset some or all of your investment gains.
See a tax professional. There are other ways to minimize your mutual fund taxes, too, so find a CPA or other tax professional and discuss your options.
» Ready to dive in? See our list of the best brokers for mutual funds
As an expert and enthusiast, I can provide you with information on various topics, including mutual fund taxes. I have access to a wide range of knowledge and can provide insights based on that information. Let's dive into the concepts mentioned in the article you provided.
Mutual Fund Taxes: An Overview
Mutual fund taxes typically include taxes on dividends and earnings while the investor owns the mutual fund shares, as well as capital gains taxes when the investor sells the mutual fund shares. The tax rate and the tax on mutual funds depend on the type of distribution and other factors.
Tax on Mutual Funds if You Receive Dividends or Interest
Dividends received from mutual funds are usually considered taxable income. When you invest in a mutual fund, you have the option to choose whether you want your share of the dividends distributed to you or automatically reinvested into the mutual fund. Even if you choose to reinvest your dividends, the IRS generally still considers that money taxable. Similarly, if your mutual fund invests in bonds and receives interest payments, your portion of that interest may also be taxable income, even if you reinvest it. However, the interest on certain bonds, such as municipal bonds and U.S. Treasuries, may be tax-free.
If your mutual fund distributes dividends or interest during the year, you will likely receive an IRS Form 1099-DIV or 1099-INT the following January, which shows how much you received from the fund. You will need to use this form to report the income on your tax return.
Tax on Mutual Funds if Fund Managers Generate Capital Gains
If the mutual fund's managers sell securities in the fund for a profit, your share of that profit is considered a capital gain. Generally, mutual funds distribute these net capital gains to investors once a year. Capital gains are taxable income, even if you reinvested the money. You will likely receive an IRS Form 1099-DIV in January, showing your portion of the fund's capital gains during the previous year. You will need this form to report your capital gain on your tax return.
Tax on Mutual Funds When You Sell
When you sell your mutual fund shares, you may be subject to taxes. If you sell the shares for more than you paid or for more than the cost basis, the profit is considered a capital gain and is taxable income. The method you use to determine which shares you're selling and how much profit you're making can influence how you calculate your profit and how much tax you might owe. The length of time you own your mutual fund shares also matters, as owning them for more than a year before selling may result in a lower capital gains tax rate.
Tips to Minimize Tax on Mutual Funds
Here are six quick tips to help minimize the tax on mutual funds:
- Wait as long as you can to sell: Selling mutual fund shares in less than a year can trigger higher capital gains taxes if you make a profit.
- Buy mutual fund shares through your traditional IRA or Roth IRA: Investing through these accounts can provide tax advantages, such as tax-deferred growth or tax-free withdrawals, depending on the type of account.
- Buy mutual fund shares through your 401(k) account: Similar to IRAs, investing through a 401(k) account can provide tax advantages, such as tax-deferred growth.
- Know what kinds of investments the fund makes: Understanding the types of investments a mutual fund holds can help you manage taxable dividends and capital gains distributions.
- Use tax-loss harvesting: If your investments are in a taxable account, you may be able to offset some taxes by selling other underperforming mutual funds or securities at a loss.
- Consult a tax professional: There are other strategies to minimize mutual fund taxes, so it's a good idea to seek advice from a CPA or other tax professional to discuss your options.
Remember, these tips are general guidelines, and it's important to consult with a tax professional to understand how they apply to your specific situation.
I hope this information helps you understand the concepts related to mutual fund taxes. If you have any further questions, feel free to ask!
