The purpose of mutual fund investing is to make money, and when you make money, the government wants its share in the form of taxes. The rules concerning how a mutual fund pays out earnings and profits affects your taxes for each year you own mutual fund shares. Understanding how a mutual fund works in regard to taxes helps you to plan ahead for any tax consequences from your investments.
Mutual Fund Distributions
Mutual funds are required to pay out earnings from a fund's portfolio to investors in the form of dividends or capital gains. A fund typically pays dividends -- which come from interest or dividends earned by the fund -- quarterly or monthly. If a fund has sold investments for a profit, those profits are distributed at the end of the year in the form of capital gains. Even if you are reinvesting your dividends and capital gains, the distributions are taxable earnings or gains to you. The only non-taxable distribution from mutual funds are dividends paid by mutual funds investing in municipal bonds.
Tax Reporting Information
At the start of each year the mutual fund investment house will send you an IRS Form 1099, which lists the dividends and capital gains you earned from the fund during the previous year. The 1099 lists amounts for long- and short-term capital gains and the types of income you earned in the form of dividends. These amounts must be included on your annual income tax return. The gains and income will increase your taxable income and total tax bill. However, long-term capital gains and qualified dividends are taxed at lower rates than your regular income tax bracket, so the increase in taxes will be smaller than for the same amount of earned income.
Selling Mutual Fund Shares
You also incur a taxable event if you sell mutual fund shares during the year. When you sell shares you will produce a taxable gain or tax-deductible loss. The dividends and capital gains that have been reinvested into more shares increase your cost basis in the fund and reduce the amount of any gain or increase the size of the loss. Losses on the sale of mutual fund shares are classified as capital losses and can be used to offset other capital gains or a portion of your regular income. Mutual fund losses can only be claimed if you sold the shares during the year.
Reducing Mutual Fund Tax Consequences
There are several strategies you can use to reduce the tax consequences of investing in mutual funds. If you buy funds through a qualified retirement account such as an IRA or Roth IRA, the earnings can be reinvested and grow tax-deferred or tax-free, respectively. For income funds, look at tax-free municipal bond funds to earn tax-exempt dividends. To minimize the amount of capital gains you must report, consider stock mutual funds with a low investment turnover percentage. A mutual fund generates capital gains from selling stocks it owns. If a fund holds onto stocks instead of selling, there will be no capital gains to pass on to mutual fund investors.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.