Mutual Fund Tax Guide

The tax treatment of mutual funds is somewhat different — often more favorable but also more complicated — than the tax treatment of other stocks.

The following pages offer general observations concerning mutual funds, together with details concerning the tax treatment of mutual fund dividends, distributions and allocations. Special rules that apply when you sell mutual fund shares are covered separately as part of our guide to capital gains and losses.

details: Selling Mutual Fund Shares

can fall into a number of categories with various tax treatments. Sales of mutual fund shares are also subject to special rules. This guide offers complete details.

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.

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.

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.

Tax planning for mutual fund investments

Separate Lots vs. Averaging
Considerations in choosing between using the separate lot method or the average basis method for maintaining the basis of your mutual fund shares.

Mutual Funds in Retirement Accounts
Most of the rules in this guide don’t apply if you hold a mutual fund investment inside a retirement plan. This page explains tax considerations that apply in this case.

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