Tax Guide for Mutual Fund Distributions
The distributions of income and capital gains you get from funds are taxed according to principles that are often perplexing and sometimes unfair. This guidebook covers the basic rules.
The rules are for fund shares in taxable accounts. They are largely irrelevant to the taxation of funds held in IRAs and 401(k)s.
1. Flow-Through. Funds don’t pay corporate income tax. Instead, they flow their dividends, interest and capital gains through to their shareholders, who declare these on their own tax returns. The distributions are taxable whether or not the shareholder reinvests them in the fund.
Income comes in different tax flavors: municipal bond interest, U.S. Treasury interest, fully taxable interest, dividends that qualify for the favorable rate, dividends that don’t qualify, short-term gains, long-term gains. For the most part, the flavors flow though, just as they would in a partnership.
There are two big differences between partnerships and funds. Partnerships can flow through losses as well as gains; funds can’t. Partnerships can flow through short-term gains; in a fund, these gains decay into less-desirable ordinary income.
2. Hot Potato. A distribution—and the tax bill that sticks to it—is delivered to whoever is holding the fund when the distribution goes out. This isn’t necessarily someone who is making money.
Say you buy a fund share for $20 and a month later, with the fund still worth only $20, you get a $1 distribution. Immediately thereafter, the fund share value drops to $19.
So far, you are only breaking even, but you owe tax on the $1 distribution. You can partly or fully offset that tax by cashing out the fund share at $19, creating a $1 capital loss. But you are inconvenienced and, if you are one of the unfortunates still buying funds with sales commissions, out the commission.
Prevent this problem. Avoid buying funds near the end of the year, when lump-sum distributions are common.
3. Corporate Dividends. Dividends from corporations like ExxonMobil and Apple qualify for a reduced federal tax rate. Most people pay a 15% federal rate on dividends; a few low-income shareholders get a free ride and the wealthy pay a 20% marginal rate. (Most states, in contrast, hit dividends with their usual tax rates.)
The favorably-taxed divs flow through to fund investors, and many funds invested in stocks can boast that 100% of their income distributions qualify for favorable treatment. But at some funds, the percentage qualifying is substantially less.
A fund can fall short of 100% purity on its dividend income several ways. Dividends from real estate investment trusts, and from many foreign corporations, don’t qualify for the low rates. The fund can mess up your taxes by trading a lot because the tax break is lost for positions held a short time.
Funds with European stocks and smaller U.S. stocks often lend securities to short-sellers. The shorts make payments to the funds to replace missing dividends, and those substitute payments do not get the favorable tax rates.
4. Muni Interest. A fund that owns “municipal” bonds (bonds sold by states, cities, nonprofits and so on) can flow through federally tax-exempt interest to its investors. To do so, the fund must have at least 50% of its assets invested in these bonds. No surprise that funds mixing stocks and munis stay on the safe side of the barrier.
5. AMT Gotcha. If the muni bond finances a government or a charity, it gets the federal exemption. If the bond finances a “private activity” like an airplane hangar, it is exempt only for certain taxpayers. Taxpayers who are subject to the Alternative Minimum Tax have to include the interest on their tax returns.
Your tax-exempt bond fund might report that you got $1,000 of interest and that $150 of the amount was from private activity bonds. If you are in AMT territory—likely if your income is between $200,000 and $500,000 and you live in a high-tax state—then you’d pay federal tax on the $150.
AMT bonds, which have a whiff of crony capitalism, are often of low credit quality. So you’ll see them in junkier muni portfolios. They also populate money-market funds.
6. Out-of-State Munis. Most states exempt interest on their own municipal bonds from state income tax, while whacking the coupons from other states. And most states let you count fractional revenue streams.
Let’s say you live in New Jersey and your fund reports that you got $1,000 of tax-exempt interest, 12% from New Jersey sources. On your New Jersey tax return you’d include $880 of this interest.
Utah and Indiana use a tit-for-tat tax system that gives you a somewhat better break. (They tax another state’s bonds only if that state taxes their bonds.) Minnesota has a worse deal: The entire interest payout is taxable unless at least 95% of it came from Minnesota.
Illinois has the worst arrangement of al. That state taxes all fund payouts, even payouts entirely from Illinois bonds. You get a local tax exemption only by buying Illinois bonds directly—a hazardous undertaking, given the state’s sickly finances.
7. Treasury Interest. States exempt from tax the interest on U.S. Treasury debt. They usually pro-rate distributions from funds that own a mix of Treasury and non-Treasury securities. California, Connecticut and New York, however, permit this carve-out only if a certain percentage of the fund’s payout or assets is Treasury-flavored. In New York the hurdle is 50% of assets.
8. Foreign Tax Credit. You can claim a federal tax credit (which is better than a deduction) for foreign taxes, and you can claim the foreign taxes paid on your behalf by a fund. If your foreign tax credits total more than $600 on a joint return, you’ll need some detail, including each fund’s foreign-source income and foreign taxes paid. The fund will either give you the numbers or give you a way to calculate them.
If you hold the fund in a tax-sheltered account, you lose the credit (permanently). Try to own your international funds in a taxable account.
9. Short-Term Trouble. Short-term trading gains by your fund get converted on your tax return into less-desirable ordinary income. (Why? Years ago, Congress determined that trading by fund managers was wicked.) The only consolation is that some funds are able to shelter you from some of this damage by creative use of their corporate dividend income. How is that possible? It relates to the fact that fund expenses can be taken against the short gains rather than against the dividend income.
Suppose that, per fund share, the fund’s corporate dividend income was $5, its expenses 80 cents, and its short gains $3. It distributes $7.20, and would describe this in shareholder reports as $4.20 of income and $3 of capital gains. But on the 1099s sent out to customers it would declare $5 of dividend income eligible for the low rates and $2.20 of ordinary income.
Notwithstanding the possibility of this fancy footwork, short gains are likely to be bad news at tax time.
10. Long-Term Trouble. If a fund sells a stock that it has held for more than a year, the gain or loss is long-term. Net long-term gains are dished out to the shareholder’s tax return, where they retain their flavor. (It doesn’t matter how long the fund investor has held the fund.) Since long gains get the same favorable rates as dividends from Exxon (0%-15%-20%), they aren’t too nasty. Still, it’s better if the fund sits on winners and doesn’t inflict gains on its customers at all.
By William Baldwin for Forbes Magazine