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.
A distribution classified as "return of capital" is, in effect, giving back to you part of the purchase price of the fund shares, and is not taxable.
Distributions from mutual funds are taxable even if you do not actually receive the cash "in hand". Many investors elect to have some or all of the distributions reinvested in the fund. Reinvested distributions are treated as if you received a cash distribution from the fund and then turned around and used the cash to purchase additional shares in the fund, and, unless they represent a "return of capital," are fully taxable.
Since reinvested dividends are actually additional purchases of fund shares, they are added to the cost basis of your investment. Dividends reinvested over the years are added to your initial investment and any subsequent purchases and will decrease your taxable gain, or increase your deductible loss, when you sell the fund.
You invested $1,000.00 in the XYZ Mutual Fund in 2006, and elected to have all distributions reinvested. Between 2006 and 2013 you received $700.00 in taxable distributions, which were reinvested in the fund. At the end of 2013 you sell all your shares in the fund for $1,200.00. You have a $500.00 capital loss ($1,000.00 plus $700.00 = $1,700.00 less $1,200.00 = $500.00).
Because distributions that are a "return of capital" represent a refund of your purchase price they are subtracted from your cost basis when determining the gain or loss on the sale.
If you sell less than your entire investment in a mutual fund (i.e. you own 1,000 shares of the XYZ Mutual Fund and sell 400 shares) there are four (4) methods available to you to determine the "cost basis" of the shares sold. These four methods are:
- Actual cost basis using specific identification,
- Actual cost basis using first-in, first-out identification,
- Average cost basis, single-category method, and
- Average cost basis, double-category method
You can elect the method that results the least amount of gain or the greatest amount of loss. You can use different methods for sales of different mutual funds, but once you use a method for the sale of shares of a particular fund you must use the same method for all sales of that fund. If you use the Average Cost single-category method to determine the cost basis for your first sale of XYZ Mutual Fund shares, you must use the Average Cost single-category method each time you sell shares of the XZY Mutual Fund.
The mutual fund will often send you an "Average Cost Statement" for the shares sold, generally using the Average Cost single-category method. This Average Cost Statement is not sent to the IRS, but is for your information only.
The Form 1099-DIV you receive from the mutual fund in February identifies the amount of the various distributions for the year by category. It reports total ordinary dividends, qualified dividends, capital gain distributions, unrecaptured Section 1250 and collectibles gains, non-taxable distributions (return of capital), and "tax-exempt" dividends from fund investments in tax-free mutual bonds. It also reports investment expenses deducted from ordinary dividends (which may be deductible as a Miscellaneous Expense if you itemize), and any federal, state or foreign tax withheld from the distributions.
Mutual fund dividends resulting from fund investments in tax-free municipal bonds are exempt from federal income taxes but may be taxable on your state return, depending on the source of the dividends. Information on the source of federally tax-exempt income is usually provided by the fund or fund family and may also be available online.
Dividends from a mutual fund that represent income from a direct obligation of the United States government, such as Treasury bills, Treasury bonds, Treasury notes, and U.S. Savings Bonds, which are fully taxable on your federal return, may be exempt from state income taxes. Mutual funds often provide information on what % of ordinary dividends are from US government obligations in the Form 1099-DIV package. This information may also be available on the website of the mutual fund or fund family.
You will receive a Form 1099-B to report the "gross proceeds" from any sales of shares in the mutual fund during the year. The mutual fund sends a copy of both the 1099-DIV and 1099-B to the IRS.
It is very important that you save all purchase "confirmation" slips and annual account statements for the fund for as long as you own shares in the fund.
--Written by Robert D. Flach for MainStreet