Mutual Fund Taxation

Understanding how mutual funds are taxed is essential for making suitable recommendations. Mutual funds are "pass-through" entities — they pass income and gains to shareholders who are then responsible for taxes.

Types of Mutual Fund Distributions

1. Ordinary Dividends

Income from interest and non-qualified dividends passes through as ordinary dividends, taxed at the investor's ordinary income tax rate (up to 37% in 2025).

2. Qualified Dividends

Qualified dividends receive preferential tax treatment (0%, 15%, or 20% depending on income). To qualify:

• Must be paid by a U.S. corporation or qualified foreign corporation
• Investor must hold shares for more than 60 days during the 121-day period around the ex-dividend date

3. Capital Gains Distributions

When the fund sells securities at a profit, it distributes capital gains to shareholders:

Important: Capital gains distributions are always treated as long-term for tax purposes, regardless of how long you've owned the fund shares.

4. Return of Capital

Return of capital distributions are not taxable when received. Instead, they reduce your cost basis. If your basis reaches zero, further return of capital is taxed as capital gains.

Tax Treatment Summary

Cost Basis Methods

When you sell mutual fund shares, you need to determine your cost basis to calculate gains or losses. The IRS allows several methods:

1. Average Cost Method

Most common for mutual funds:

Average Cost = Total Cost of All Shares ÷ Number of Shares

2. First-In, First-Out (FIFO)

Assumes the first shares purchased are the first shares sold. Often results in higher gains (and taxes) because older shares typically have lower cost.

3. Specific Identification

Investor specifies which shares to sell. Requires detailed records but offers the most tax planning flexibility.

Reinvested Distributions

When you reinvest dividends and capital gains distributions:

• You still owe taxes on those distributions (even though you didn't receive cash)
• The reinvested amount increases your cost basis
• This prevents double taxation when you eventually sell

Example

• You receive a $500 capital gains distribution
• You reinvest it, buying more shares at $50/share (10 new shares)
• You owe taxes on the $500 distribution this year
• Your cost basis increases by $500

Tax-Exempt Funds

Municipal bond funds invest in state and local government bonds. Interest is:

• Exempt from federal income tax
• May be exempt from state tax if you live in the issuing state
• Capital gains are still taxable

Exam Tip: Tax-exempt funds are most beneficial for investors in high tax brackets.

Wash Sale Rule

The wash sale rule prevents investors from claiming a tax loss if they buy "substantially identical" securities within 30 days before or after the sale.

• Applies to mutual funds
• 61-day window (30 days before + sale date + 30 days after)
• Disallowed loss is added to the cost basis of the new shares

Tax-Advantaged Accounts

In tax-advantaged accounts (IRA, 401(k), 403(b)):

• Distributions are not taxable in the year received
• Taxes are deferred until withdrawal (Traditional)
• Withdrawals may be tax-free (Roth)
• Cost basis tracking is not required

Form 1099-DIV

Mutual funds send Form 1099-DIV annually, reporting:

• Ordinary dividends
• Qualified dividends
• Capital gains distributions
• Return of capital
• Foreign taxes paid