Find out more about mutual funds, how distributions work, and how you’re taxed when you get them.
What Are Mutual Fund Distributions?
Companies that are not mutual funds can choose between keeping their earnings or paying them out to shareholders. A mutual fund is a business that sells portions of its holdings to you. The share portions are grouped, and you buy a bundle of them. You place money into the fund, and the managers put the money into the stocks per the fund’s goals. When the fund makes a profit, they have to pass on the funds by law. Your earnings represent your share of the profits. There are many mutual funds with different missions and guiding ideas, but each must give profits back to you. It is vital to know how your earnings are taxed, because it can help you predict costs and taxes and make decisions.
How Dividend and Distribution Taxes Work
Ordinary dividends are the income from a mutual fund that is not from capital gains. You get a gain if the fund managers sell shares for a profit. Those gains are passed on as distributions and are taxed at the capital gains tax rate. If you’ve held your shares longer than one year, the earnings are taxed at the capital gains tax rates for your income bracket. If they were held for less than a year, they are taxed as ordinary income. For a mutual fund, a dividend is interest the fund created and passed on to you as ordinary income. If dividends meet certain criteria, they become qualified dividends and are taxed differently. Ordinary income (dividends) is not considered a qualified dividend. The payout is taxed at your annual income tax rate.
What Are Qualified Dividends?
According to the IRS definition, qualified dividends are: Your profits are considered qualified by the IRS if:
They were paid by a U.S. business or eligible foreign company.They not listed as a type that is not a qualified dividend.You have held the stock for more than 60 days over a 121-day period.
The 121-day period must begin 60 days before the ex-dividend date. The ex-dividend date is the first day after the last dividends were declared.
How Are Qualified Dividends Taxed?
Qualified dividends are taxed as ordinary income, but since the IRS qualifies them, they are based on capital gains tax rates. The following chart shows how your qualified dividends will be taxed: Depending on your aversion to risk and your goals, you can choose among high-, medium-, and low-risk funds that match the risk with return. You might also consider buying funds that help you diversify your holdings to help mitigate the risks of investing. There is one common mistake that many newer investors make. Some try to time their purchase so that they receive a dividend. This is called “buying the dividend.” While you might get a dividend from this tactic, you’ll be responsible for paying taxes on it. The problem with this strategy is that when you are paid, the stock value drops in the payment amount. For example, you bought a fund with one share valued at $1,000 right before a dividend. The next day the fund paid out, and you received a $5 payment. The share’s value then dropped to $995. If you’re in the 16% to 36% income tax bracket, you’d owe 15% of that payment in taxes. You’d only have $4.25 left to reinvest or keep; in other words, you’d lose money on your purchase, because the total value you’d have left over after a dividend would be $999.25. If you plan a large lump-sum buy in a mutual fund in your taxable account, you should check the fund’s distribution schedule. Adjust your buying plan to avoid buying the dividend if you’ll pay taxes that will cause you to lose money.
The Bottom Line
Mutual fund distributions can provide you with income from your portfolio. However, it’s important to understand how they are taxed. Knowing the difference between the mutual fund distribution options can help you lower your tax liability each year.
