How Are Mutual Fund Distributions Taxed?

Editor's Note: This article is part of our 2013 Tax Tips series. Robert Flach is an expert with almost 40 years of experience as a tax professional and also blogs as The Wandering Tax Pro.

NEW YORK (MainStreet)—A mutual fund pools money from thousands of small investors and uses the money to buy stocks, bonds or other securities. These funds allow a small investor to have a diversified portfolio without having to buy individual stocks and bonds.

Distributions from a mutual fund are earnings from the fund's operation. A mutual fund is required by law to distribute its profits to the shareholders.

Mutual funds make three types of distributions - ordinary dividends and capital gain distributions, which are paid out of the income of the fund, and, on occasion, a "return of capital", which is paid out of principal.

Some or all of the ordinary dividends distributed by a mutual fund may also be "qualified dividends".

Ordinary dividends are usually (subject to an income threshold) reported on Part II of Schedule B. Ordinary dividends that are not considered "qualified" are taxed as "ordinary income" at the taxpayer's normal tax rate. Qualified dividends are taxed at the applicable lower capital gain rates.

Capital gain distributions are treated the same as long-term capital gains from the sale or exchange of investments. They are reported on Schedule D and taxed at the applicable lower capital gains rate.

Capital gain distributions may include gain from the sale of "collectibles" and unrecaptured Section 1250 gain, which are taxed at higher rates. These gains are identified on the Form 1099-DIV.

The lower tax rates for "qualified dividends" and applicable "capital gain distributions" are –

  • 0% - if your taxable income (including capital gain income) places you in the 10% or 15% tax brackets,
  • 15% - if your taxable income (including capital gain income) places you in the 25% to 35% tax bracket or higher.
  • 20% - if your taxable income (including capital gain income) places you in the 39.6% tax bracket (more than $400,000 for Single filers, $425,000 for Head of Household and $450,000 for married Filing Joint).

If your "modified" Adjusted Gross Income is over $200,000 for single and head of household filers, $250,000 for married filing joint filers and qualifying widows or widowers, and $125,000 for married filing separately filers your taxable mutual fund distributions may be subject to the 3.8% Unearned Income Medicare Contribution Tax.