The Taxman Cometh Part II
August 29, 2010 | In: mutual funds
Last week we took a closer look at how mutual funds are taxed with a focus on equity funds. This week, hopefully, some light will be shed on income funds and how they’re taxed. It’s relatively simple, as dividend income is taxed at your personal tax rate; however, there are a few other aspects of income funds that you may not be aware of that may help you better plan your financial future. Keep in mind the information contained in this article is meant simply as a helpful guide, and that you should always consult your tax advisor for information on your personal tax situation.
As we stated last week, there are several ways that the investments you have in mutual funds are taxed. We discussed capital gains distributions, capital gains on sale of shares, as well as dividend and interest income. It is somewhat more complex than this, however for the purpose of this article, the descriptions are simplified. Remember, if you have received distributions from a mutual fund, you can not file form 1040EZ, you would either file a 1040 or 1040A.
Mutual funds receive dividends on shares they own and distribute this income to shareholders. Dividends, also referred to as ordinary dividends, are taxable whether you take them in the form of cash or reinvest them. They are the most common type of dividends and are reported in box 1 of the 1099-DIV. They are taxed at your personal tax rate. (There are certain exceptions however to this rule, including dividends from municipal bond funds and tax sheltered retirement accounts (your IRA’s, 401k’s, etc)). When dividends are reinvested, it means you purchased more shares with the dividend dollars, which then becomes part of your cost basis when you decide to sell some shares.
Remember, when you receive an ordinary dividend distribution from your fund, you’re actually receiving income, which the fund received as interest, dividends, and net short-term capital gains. For tax treatment purposes, these ordinary dividends are taxable during the year they’re declared by the fund, as opposed to when they’re actually received.
Interest income is derived from US Government Treasuries, corporate bonds, municipal bonds, etc. This also is taxed at your ordinary tax rate. You’ll see this type of interest income on any of your money market funds, bond funds, or tax-free municipal bond funds. One of the most common questions I used to get was “how can I owe federal taxes on a ‘tax free’ bond fund?” The confusion lies in that the monthly income (dividends) paid by your fund is not subject to federal income tax, however, any short-term or long-term capital gains the fund pays are fully taxable and are reported on Form 1099-DIV. The main point to remember here is that although federal tax-free funds may be tax-free at the federal level, they may be subject to individual state taxes.
There are a couple of other items you may see at tax time which are less common, but deserve a quick review. They are exempt-interest dividends and undistributed capital gains. If a mutual fund meets certain IRS requirements, a mutual fund may be allowed to pay exempt interest dividends to its shareholders. These dividends are paid from tax-exempt interest earned by the fund and are not reported as income. These dividends are not shown on Form 1099DIV, but you will receive a separate statement from your mutual fund company 60 days after the close of its tax year. Although not taxable, they must be reported on your tax return.
Mutual funds may keep some of their long-term capital gains and pay taxes on those undistributed amounts. They are allocated as capital gains distributions even though shareholders may not actually receive a distribution. This type of distribution is noted on Form 2439, and will indicate your share of the undistributed capital gains and any tax paid by the mutual fund. This gain is not reported on Form 1099dIV, but it must be entered on the 1040 filing.
These articles on mutual fund taxation have hopefully served as an introduction to the complexities of the taxing business of mutual funds. Volumes can, and have been written (just take a look at the actual IRS tax code) about the taxation of investment dollars. Although designed to take some of the mystery out of our yearly April 15th ritual, every individual taxpayer would benefit from using the list of publications provided by the IRS. Don’t let the forms you receive intimidate you. They’re all numbered and provide you with all the information you need to have your taxes done properly, but remember, it’s always a good idea to consult with a professional before you sign and date your tax forms!
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