Mutual Fund Tax Guide

Within a retirement account or other tax-favored investment vehicle, such as a 529 plan, mutual funds generally produce no special tax results. It’s a different story if you own mutual fund shares in a normal, taxable account. In this case, you may encounter a number of special rules that apply to dividends and other distributions. What’s more, there are special rules for selling mutual fund shares. Most, but not all, revolve around the ability to use average basis to figure gain or loss.

Overview

Mutual Funds 101
An introduction to mutual funds and a brief description of the tax issues that are covered in more detail elsewhere.

Dividends, Distributions and Allocations

The tax rules for mutual funds are intended to permit them to act more or less as a flow-through entity. When the mutual fund has long-term capital gain, for example, a portion of the dividend it pays to its shareholders will be treated as long-term capital gain. Generally this treatment is beneficial, but it means tax reporting for mutual fund dividends is more complicated than tax reporting for dividends paid on regular stocks. These pages provide guidance on the issues.

Mutual Fund Ordinary Dividends
Ordinary dividends include taxable income other than long-term capital gain. They are not necessarily taxed at ordinary tax rates, though, because this category can include qualified dividends that are taxed at lower rates.

Capital Gain Distributions
Your mutual fund distribution may include long-term capital gain. This part of the dividend generally qualifies for favorable tax treatment.

Exempt Interest Distributions
If your mutual fund invests in municipal bonds or other state and local government obligations, some or all of its distributions will be treated as exempt interest. Although these payments aren’t included in your taxable income, they can affect the taxation of Social Security benefits or, for certain kinds of bonds, cause you to pay alternative minimum tax (AMT).

Federal Interest Dividends
If your mutual fund invests in debt obligations of the federal government, you may be able to treat some or all of its distributions as federal government interest. This category of income does not receive any special treatment on your federal income tax return but is exempt from state income tax.

Nondividend Distributions
Sometimes a mutual fund makes a payment that doesn’t represent income — not even exempt income. It’s simply returning some of the money you invested. Generally you don’t have to report these payments, but you have to adjust the basis used to figure the amount of gain or loss when you sell your shares.

Foreign Tax Paid
If your mutual fund pays foreign tax, it may allocate it among shareholders, allowing you to claim a deduction or credit.

Form 2439 Capital Gain Allocations
Nearly all mutual funds make capital gain distributions, so it’s unlikely you’ll encounter a capital gain allocation. If you do, your mutual fund will send Form 2439, and you’ll have to deal with some special rules.

Other Issues for Mutual Fund Dividends
Answers to additional questions relating to reinvested dividends, tax reporting, and January dividends.

Selling Mutual Fund Shares

You can use either the separate lot method or the averaging method to determine your basis in mutual fund shares you sell. The following pages explain these alternatives and how to take advantage of them. Also explained are two special rules that can apply to sales of mutual fund shares: the sales load deferral rule, and a rule dealing with mutual fund shares held six months or less.

Overview of Cost Basis Methods
A bird’s eye view of how cost basis methods and disposition methods work together.

Changes in the Averaging Rules
The averaging rules changed dramatically when the cost basis regulations began to apply to mutual fund shares in 2012. This page briefly describes the key differences.

Electing a Cost Basis Method
Steps you have to take when choosing to use the separate lot method or the average basis method.

Using the Separate Lot Method
This page illustrates the steps required — and the difficulties involved — in maintaining records of your mutual fund investments using the separate lot method.

Using the Average Basis Method
Basis calculations are easier when using this method.

Changing Cost Basis Methods
Current rules are more liberal than the prior ones in permitting you to switch back and forth between methods.

Special Rule for Gift Shares
This rule matters only if you receive a gift of mutual fund shares with a date-of-gift value greater than the donor’s basis, and you’re using (or want to elect) the average basis method.

Double-Category Averaging Method
This method no longer exists, so the information here is of interest only if you used this method in the past.

Sales Load Deferral Rule
A special rule that applies if you avoid paying sales load on a new purchase due to having paid it on a previous purchase.

Shares Held Six Months or Less
Special rules can apply to loss on mutual fund shares held six months or less.