How are mutual fund distributions taxed?

You must generally report as income any mutual fund distribution, whether or not it is reinvested. The tax law generally treats mutual fund shareholders as if they directly owned a proportionate share of the fund’s portfolio of securities. The fund itself is not taxed on its income if certain tests are met and substantially all of its income is distributed to its shareholders. Thus, all dividends and interest from securities in the portfolio, as well as any capital gains from the sales of securities, are taxed to the shareholders.

There are two types of taxable distributions: ordinary dividends and capital gain distributions.

Ordinary dividends are the most common type of distribution from a corporation and are paid out of the earnings and profits of the corporation. For mutual funds, this is the interest and dividends earned by securities held in the fund’s portfolio that represent the net earnings of the fund. Ordinary dividends are periodically paid out to shareholders and are taxable as ordinary income unless they are qualified dividends. Qualified dividends are ordinary dividends that meet the requirements to be taxed as net capital gains and are included with your capital gain distributions as long-term capital gain, regardless of how long you have owned your fund shares.

Like the return on any other investment, mutual fund dividend payments decline or rise from year to year, depending on the income earned by the fund in accordance with its investment policy. You should receive a Form 1099-DIV, Dividends and Distributions, from each payer for distributions of $10.00 or more; however, even if you do not receive a Form 1099–DIV or Schedule K-1 (dividends received through a partnership, an estate, a trust, or a subchapter S corporation), you must still report all taxable dividends.

Ordinary dividends are taxed at ordinary tax rates for whatever tax bracket you fall under. Qualified dividends are taxed at a 15 percent rate.

Capital gain distributions are the net gains, if any, from the sale of securities in the fund’s portfolio. When gains from the fund’s sales of securities exceed losses, they are distributed to shareholders. As with ordinary dividends, capital gain distributions vary in amount from year to year and are reported on Form 1099-DIV, Dividends and Distributions. Capital gain distributions are always reported as long-term capital gains for tax purposes. The tax rate is 15 percent for higher tax brackets (25-35 percent), but if your tax bracket is 10 or 15 percent, the tax rate for long-term capital gains is 20 percent starting in 2013.