Taxes and Mutual Funds

Most investment vehicles are taxed sooner or later, and mutual funds are no exception. If you receive yearly distributions from your fund, they are taxable. Even if you choose to automatically reinvest these distributions, they have to be treated as if you had received them in cash for tax purposes.

One thing to note is that you should ask your fund on what date distributions are recorded, usually in November, sometimes in December. Even if you do not actually receive your distribution until January, you must still report them on your taxes for the year they were recorded. So if your fund recorded a distribution on November 15, 2007, and you received it in January; you would report it on your 2007 taxes, even though it would be 2008 when you actually received it.

There are four general types of mutual fund distributions, and they have some differences in how they are considered with regards to your taxes.

First of all, you have standard dividends. They are distributions directly from the funds profits, and they are taxable as capital gains. Then there are capital gains distributions. This is a distribution of the long-term capital gains received by the fund. These are taxed at the capital gains rate, as well.

Next you have what is called exempt-interest dividends. Some funds earn interest that is tax-exempt, such as certain types of bonds. You don't have to pay regular tax on the share you receive from this interest, unless is is subject to the alternative minimum tax.

Finally, there is return of capital distributions. If the earning does not come directly out of the fund's earnings, it is a return of your own investment. This type of distribution is not taxed at all. These distributions are also called tax-free dividends.

Certain things other than distributions are taxable. For example, if you exchange your shares in one fund for shares in another fund outside your first fund's “family”, it is considered by the IRS as you having sold the shares. Also, if you have check-writing privileges, then writing a check will be taxable, because shares of the fund will be sold to cover the amount of the check.

If you are reinvesting your distributions into the same fund, you should be careful to record the distributions in your records into your cost basis (the original cost of your shares). If you do not do this, you could be taxed twice on the same money. This happens because you are taxed for both the distribution, and again when you sell the shares later. You may also be taxed if you don't increase your cost basis for undistributed capital gains. The fund will send you a Form 2439. This form will tell you the amount you need to add to your cost basis. If you have any questions about these issues, consult your fund manager, broker, or a tax professional.