Taxes on Mutual Funds: How They Work, When They’re Due

You can incur taxes while you own your mutual fund and when you sell shares. The tax rate depends on the type of distribution and other factors.

Taxes on mutual funds that you own

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.

Generally speaking, two things can trigger a tax bill on mutual funds you own: (1) dividends or interest paid out to you from the fund, and (2) securities sold by your fund manager.

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 agency will know 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 a 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

Taxes 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, which is considered 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 owned 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.

» Ready to dive in? See our list of the best brokers for mutual funds.

When do you pay taxes on mutual funds?

Any income generated from a mutual fund is reported and paid in April when you file your annual tax return. This is true whether the income was from dividends, interest or capital gains. Some investors may need to pay estimated taxes if they suspect their regular withholding may not cover their tax liability. IRS Publication 550 has the full details on the tax rules for investment income and expenses.

Good tax software should guide you through the process of reporting this income and tell you which forms and schedules you'll need to file alongside your 1040.

» Ready to file? Read our review of the best tax software

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