- How do I Offset Mutual Fund Distributions?
- What Is a Mutual Fund Cost Basis Statement?
- The Tax Implications of Selling Mutual Funds & Buying New Mutual Funds
- How to Determine the Cost Basis for Mutual Funds
- Does Reinvestment of Dividends & Capital Gains Increase the Cost Basis of Mutual Funds?
- Taxes on Mutual Fund Distributions in an IRA
Most mutual funds allow you to reinvest distributions in additional shares automatically. The Internal Revenue Service collects the same amount of tax whether you sink distributions back into a fund or pocket them. However, reinvested dividends affect the cost basis of your shares and therefore have an impact on your tax bill.
Mutual funds must distribute almost all of their income and capital gains to maintain their tax status -- funds pay no tax, but pass the obligation through to investors. Funds earn income through interest and dividends. They also earn capital gains when they sell portfolio securities for a profit. When you reinvest distributions, you buy new shares at the closing price -- called the net asset value -- on the distribution date. Each time you buy shares, you create a new "tax lot" that records the price, date and number of shares. When you sell shares, you close tax lots by identifying the specific ones you want to sell or by using the "first-in, first-out" basis.
Interest and Dividend Income
Funds issue copies of Form 1099-DIV to you and the IRS shortly after the end of the year, detailing your interest and dividend income. The IRS taxes interest income at your regular income tax rate, except for any tax-free interest you earn from municipal bonds and bond funds. Most corporate dividends qualify for lower capital gains tax rates. Certain dividends, such as those paid by foreign stocks that are not readily traded in the U.S., are nonqualified. You treat these as ordinary income for tax purposes. Form 1099-DIV reports separate totals for taxable interest, tax-free interest, and qualified and nonqualified dividends. Reinvested income has a compounding effect because the additional shares earn extra interest or dividends.
Form 1099-DIV also reports distributions of capital gains that the fund earns on portfolio sales. Treat all such gains as long-term, eligible for lower tax rates. You also create capital gains or losses when you sell fund shares. Your fund reports short-term and long-term gains and losses separately on Form 1099-B. Long-term gains arise from the profitable sale of shares you held more than a year. When you sell shares you bought through reinvestment, their short- or long-term status depends on the reinvestment date. Mutual funds allow you to make separate decisions on reinvesting income and capital gains. For example, you can instruct your fund to reinvest income but deposit capital gains into a money market account.
Capital Gains Taxes
You earn a capital gain when sale proceeds exceed the cost basis of an investment. The IRS taxes short-term capital gains at your regular rate. If your modified adjusted gross income exceeds $400,000 -- the threshold for married couples is $450,000 -- you pay 20 percent tax on long-term capital gains, as of 2013. If your MAGI is lower, you pay 15 percent if your tax bracket is 25 percent or higher. Otherwise, your long-term capital gains are tax-free. Capital losses offset capital gains and up to $3,000 of ordinary income. You can carry unused capital losses forward to future years. Report capital gains on Form 8949 and summarize the results on Schedule D of Form 1040.
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