Taxes on Mutual Funds: How Are Mutual Funds Taxed? (2024)

Text size: aA aA aA

Filling out your tax return is like compiling the index of a book — the book is complete, but you have to rummage (sometimes painfully) through your work again, assuring accuracy and factual content, in order to make the book easier for someone else to read. If you're a mutual fund investor trying to determine your taxable gain or loss for the past year, your tax return will entail additional work.

But if you've kept good records and understand some basic guidelines, the process can be relatively painless.

Tax treatment of mutual funds

The first step in evaluating your tax liability is knowing which investment transactions require payment of taxes. In general, whenever you sell or exchange shares of a mutual fund, you may have a capital gain or loss that must be reported in the tax year of the transaction. In addition, most funds receive periodic dividend or interest income from stock or bond investments and incur capital gains or losses when selling securities in the fund during the year. The fund company passes these dividends, interest, and capital gains to you, the shareholder, either in a check or through reinvested distributions. You must pay taxes on dividends, interest, and capital gains that the fund company distributes to you, in addition to capital gains on sale or exchange of shares in your account. Reinvesting distributions in more shares of the fund does not relieve you from having to pay taxes on those distributions.

The next step is understanding the difference between short- and long-term capital gains. Short-term capital gains (assets held 12 months or less) are taxed at your ordinary income tax rate, whereas long-term capital gains (assets held for more than 12 months) are currently subject to federal capital gains tax at a rate of up to 20%.Footnote1 Remember that each dollar of capital loss can offset a dollar of capital gain. In other words, if you have $1,000 in long-term gains and $600 in long-term losses, you only have to pay tax on a net long-term gain of $400. Should your losses exceed your gains, you can offset up to $3,000 of excess capital losses against ordinary income. Losses beyond $3,000 can be carried over and deducted from income in future years.

How to determine a gain or loss

In order to determine whether you have a gain or loss on a sale or exchange, you must first know your "adjusted cost basis." That's because you will be taxed on the difference between the adjusted cost basis of the fund shares and the amount you received when you sold them.

Under a federal law that took effect on January 1, 2011, financial institutions are now required to report cost basis for certain investments to investors, on Form 1099-B, which typically is made available to investors in January of the following year. The expanded Form 1099-B specifies whether a gain or loss was short-term or long-term. The cost-basis reporting requirements took effect for certain securities in 2011, and apply to mutual fund shares purchased on or after January 1, 2012.

Previously, when an investor sold a position in a security or a fund, the investor's financial firm was required to report only the gross sale proceeds to the investor and to the Internal Revenue Service (IRS). It was typically up to the investor to track the cost basis and to calculate the capital gain or loss, and the resulting tax liability, for income tax purposes. The IRS typically gives you the choice of accounting methods to determine cost basis.

FIFO, which stands for "first in, first out," means the shares you bought first are also the ones you sell first.

The specific identification method of selling shares demands more planning on your part, but also provides the most flexibility of any method for determining the amount of gain or loss on your shares. For example, if you want to select certain shares to sell in order to produce the best tax benefit for your situation, you have to specify the shares you want to sell in advance and in writing to your fund company. Then, you'll receive confirmation of your request for your tax records. Therefore, if you've sold shares of a fund in the past year, and didn't specify which shares, it's too late to use this method for that particular fund. You can, however, use specific identification in the future, as long as you haven't previously employed the single- or double-category average cost method.

The average cost method calculates your cost basis by simply averaging the purchase price of all your shares, regardless of how long you have held them. This method is particularly time-saving if you are redeeming or exchanging all shares of a fund account and have invested over many years and reinvested your dividends. But the tax result may not be advantageous if you're only redeeming a portion of the account.

Ways to Determine Cost Basis

  1. FIFO (first in, first out) — Shares bought first will be sold first.
  2. Specific Identification Method — You specify shares to be sold to provide yourself with the best possible tax benefit.
  3. Single-Category Average Cost — Simply averages the purchase price of all shares bought.

Most financial institutions use average cost as the default tax lot identification method for mutual funds, but you should check before making this assumption. Note that you may still select the cost basis reporting method you prefer, subject to certain exceptions.

Other factors to consider

Keep in mind that you can't change to another method at a future date without permission from the IRS once you've chosen single-category or double-category averaging for a particular fund. Also, you must specifically state on your return if you are using one of the averaging methods. These restrictions are not placed on shareholders using either the FIFO or specific identification method of selling shares.

If you buy shares of a fund that has a front-end load, the sales charge may be included in the cost basis of those shares. Therefore, if you send your fund company $1,000 to purchase shares that have a 5% load up front, your account would be worth $950. However, your cost basis would still be $1,000 for tax purposes. If your fund company charges a load when you sell your shares, the load should be deducted from your gain or added to your loss. For example, if you invested $1,000 in a fund and sold those shares later for $2,000 with a 2% back-end load, your gain on those shares would be $1,000 minus the load of $40 (2% of $2,000), or $960.

Also note that when you purchase additional shares as a result of reinvesting dividends and capital gains, such shares are included in your cost basis. And if you're thinking about taking losses this year in order to offset other gains, keep in mind that you cannot sell shares at a loss and buy additional shares in the same or substantially identical mutual fund within 30 days before or after the date of sale. The applicable federal tax law treats that as a "wash sale" and disallows the loss.

Some helpful hints

There's no substitute for keeping careful records of all mutual fund investments. Especially important are year-end statements, which generally list the past year's transactions, including dividends and capital gains distributions. If you're missing records for any year, ask your fund company to supply them. They'll be indispensable when preparing your tax return in future years when you sell those shares.

The above guidelines can provide you with some sense of direction as you plan to compile your "index" of taxable transactions from the past year. Of course, you may want to consult a tax professional regarding your particular situation to ensure that you are making the decisions that are best for you. It can never hurt to have someone "edit" the masterpiece you've created.

Next steps

  • Watch our video how to invest in mutual funds
  • How to choose a mutual fund

Footnote1 A 3.8% net investment income contribution tax may also apply to capital gains.

Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.

© SS&C. Reproduction in whole or in part prohibited, except by permission. All rights reserved. Not responsible for any errors or omissions.

The material was authored by a third party, DST Retirement Solutions, LLC, an SS&C company ("SS&C"), not affiliated with Merrill or any of its affiliates and is for information and educational purposes only. The opinions and views expressed do not necessarily reflect the opinions and views of Merrill or any of its affiliates. Any assumptions, opinions and estimates are as of the date of this material and are subject to change without notice. Past performance does not guarantee future results. The information contained in this material does not constitute advice on the tax consequences of making any particular investment decision. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security, financial instrument, or strategy. Before acting on any recommendation in this material, you should consider whether it is in your best interest based on your particular circumstances and, if necessary, seek professional advice.

Because of the possibility of human or mechanical error by SS&C or its sources, neither SS&C nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall SS&C be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

Banking products are provided by Bank of America, N.A. and affiliated banks. Members FDIC and wholly owned subsidiaries of Bank of America Corporation.

MAP5869811-08312024

Taxes on Mutual Funds: How Are Mutual Funds Taxed? (2024)

FAQs

Taxes on Mutual Funds: How Are Mutual Funds Taxed? ›

Like income from the sale of any other investment, if you have owned the mutual fund shares for a year or more, any profit or loss generated by the sale of those shares is taxed as long-term capital gains. Otherwise, it is considered ordinary income

ordinary income
Key Takeaways

Examples of ordinary income include salaries, tips, bonuses, commissions, rents, royalties, short-term capital gains, unqualified dividends, and interest income. For individuals, ordinary income usually consists of the pretax salaries and wages they have earned.
https://www.investopedia.com › terms › ordinaryincome
.

How are my mutual funds taxed? ›

Regardless of your income tax bracket, these gains are taxed at a flat rate of 15%. When you sell your equity fund units after holding them for at least a year, you realize long-term capital gains. These capital gains are tax-free, up to Rs 1 lakh per year.

Are mutual funds taxed twice? ›

Mutual funds are not taxed twice. However, some investors may mistakenly pay taxes twice on some distributions. For example, if a mutual fund reinvests dividends into the fund, an investor still needs to pay taxes on those dividends.

What tax rate will my mutual fund gains be taxed at? ›

Taxes on Mutual Fund Long-Term Capital Gains – Tax Year 2021 (filed in 2022)
Status of FilerSingleHead of Household
0%$0 to $40,400$0 to $54,100
15%$40,401 to $445,850$54,101 to $473,750
20%$445,851 and higher$473,751 and higher
Mar 14, 2022

How do I avoid paying taxes on mutual funds? ›

The simplest way to avoid this is to own mutual funds in tax-advantaged retirement accounts such as IRAs and 401(k)s. You can also make sure to hold the investments for the long term, so that if you do owe taxes, you'll pay them at the lower long-term capital gains rate.

Are mutual funds taxed differently? ›

Mutual fund taxes typically include taxes on dividends and earnings while the investor owns the mutual fund shares, as well as capital gains taxes when the investor sells the mutual fund shares. The tax rate (and in turn the tax on mutual funds) depends on the type of distribution and other factors.

Are mutual funds taxed as income or capital gains? ›

Capital gains distributions are paid by mutual funds from their net realized long-term capital gains and are taxed as long-term capital gains regardless of how long you have owned the shares in the mutual fund. Mutual funds may keep some of their long-term capital gains and pay taxes on those undistributed amounts.

What are the tax disadvantages of mutual funds? ›

Disadvantages include high fees, tax inefficiency, poor trade execution, and the potential for management abuses.

How are mutual fund capital gains distributions taxed? ›

Under current IRS regulations, capital gains distributions from mutual fund or ETF holdings are taxed as long-term capital gains, no matter how long the individual has owned shares of the fund.

Are mutual fund dividends taxable if reinvested? ›

If the company pays out cash dividends, you will owe taxes on those payments even if you decide to reinvest the cash received. If however, the company reinvests your dividends to purchase additional shares, you will not owe taxes until you sell those shares.

Is it good when a mutual fund gets really big? ›

In fact, bigger is definitely better for both. Portfolio management is practically on auto-pilot, so investment missteps are minimized. And, more investors mean that the fund's operating expenses are spread over a larger asset base, thus reducing its expense ratio.

Are mutual funds tax friendly? ›

Tax-Efficiency Factor: Dividends

While this may be a convenient source of regular income, the benefit may be outweighed by the increase in your tax bill. Most dividends are considered ordinary income and are subject to your normal tax rate. Mutual funds that do not pay dividends are thus naturally more tax-efficient.

How to report mutual fund on tax return? ›

Report the amount shown in box 2a of Form 1099-DIV on line 13 of Schedule D (Form 1040), Capital Gains and Losses. If you have no requirement to use Schedule D (Form 1040), report this amount on line 7 of Form 1040, U.S. Individual Tax Return or Form 1040-SR, U.S. Tax Return for Seniors and check the box.

Do I pay taxes on mutual funds if I don't sell? ›

At least once a year, funds must pass on any net gains they've realized. As a fund shareholder, you could be on the hook for taxes on gains even if you haven't sold any of your shares.

What kind of mutual fund is tax exempt? ›

No, all mutual funds do not qualify for tax deductions under Section 80C of the income tax Act, Only investments in equity-linked saving schemes or ELSSs qualify for tax deduction under section 80C. Investors can invest in ELSSs and claim tax deductions of up to Rs 1.5 lakh under Section 80C of the Income Tax Act.

Why are mutual funds bad in a taxable account? ›

When looking at the 10 largest mutual funds by asset size, the turnover ratio is almost 75% (1). This means investors will pay higher taxes in the form of distributions due to mutual fund managers selling or buying 75% of the stocks that make up their fund annually.

How much mutual fund is tax free? ›

You will get a tax deduction of up to Rs 1.5 lakh under Section 80C of the Income Tax Act. a. ELSS funds are the only tax-saving funds within the Rs 1.5 lakh limit which has the additional advantage of giving equity-linked returns.

Do I claim mutual funds on income tax? ›

This income can be capital gains, capital gains dividends, dividends, foreign income, interest, other income, return of capital, or a combination of these amounts. are taxed on the capital gain, if any. This is because your mutual fund investment is considered capital property for tax purposes.

How do I know if my mutual fund is tax saving? ›

An ELSS is a mutual fund class that offers tax deductions under Section 80C of the Income Tax Act, 1961. To check if a fund is an ELSS or not, you need to check for its details on the fund house's website. If you are investing via a third party, the same information will also be available on their website.

Can I withdraw a mutual fund anytime? ›

Can I withdraw money from mutual funds anytime? Yes, you can withdraw money from most mutual funds anytime, unless they have a lock-in period.

Top Articles
Latest Posts
Recommended Articles
Article information

Author: Nathanael Baumbach

Last Updated:

Views: 5909

Rating: 4.4 / 5 (55 voted)

Reviews: 86% of readers found this page helpful

Author information

Name: Nathanael Baumbach

Birthday: 1998-12-02

Address: Apt. 829 751 Glover View, West Orlando, IN 22436

Phone: +901025288581

Job: Internal IT Coordinator

Hobby: Gunsmithing, Motor sports, Flying, Skiing, Hooping, Lego building, Ice skating

Introduction: My name is Nathanael Baumbach, I am a fantastic, nice, victorious, brave, healthy, cute, glorious person who loves writing and wants to share my knowledge and understanding with you.