How Mutual Funds Are Taxed
Mutual funds are not the same as other investment securities, such as stocks, because they’re single portfolios. They’re called pooled investments, and they hold dozens or hundreds of other securities. The taxable activity that takes place as part of mutual fund management passes along tax liability to you, the mutual fund investor. You’ll owe tax on two levels if a stock holding in your mutual fund pays dividends, then the fund manager later sells the stock at a higher value than they paid for it:
A dividend tax, which is generally applied at your income tax rateA capital gains tax, which will be taxed at capital gains rates
It’s possible that you could receive a long-term capital gain distribution (assuming the mutual fund held the stock for more than a year) even if you’ve only held the mutual fund for a few months and you haven’t sold any shares.
How Investors Mistakenly Double Pay Mutual Fund Taxes
Let’s assume five years have passed and you sell your mutual fund. Your original investment was $10,000 worth of shares in the fund and it had paid $400 in dividends per year for five years. You’re a prudent, long-term investor, so you elected to have all dividends reinvested in more shares of your mutual fund. You did a pretty good job selecting your mutual fund, and its share price appreciation, including dividend reinvestment, gives you a final value of $15,000 when you sell. You bought the fund at $10,000 and you sold it at $15,000, so you’ll pay tax on $5,000 in capital gains, right? Yes, if you’re like millions of other investors who make the same mistake. You would pay tax on the $5,000 in “gains,” but that would be too much. Remember, your original investment was $10,000 but you also invested (or rather re-invested) $2,000 in dividends. Therefore your basis is $12,000 and your taxable gain is $3,000, not $5,000.
How To Avoid Paying Twice
The example here is simplified and it doesn’t account for compounding interest, but the lesson remains the same: Most investors think the amount they invested into the mutual fund out of their own pocket is their original investment amount or “basis” for tax reporting. But the Internal Revenue Service (IRS) says all reinvested dividend and capital gain distributions count as “investments,” too. You can avoid making the same mistake by simply keeping all your mutual fund statements and paying attention to all amounts invested. More importantly, pay attention to the amounts “reinvested.” You can also refer to IRS Publication 550. Even better, keep your statements and pass them along to your tax professional while you go about your life. The information on this site is provided for discussion purposes only, and should not be misconstrued as tax advice or investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.
