How to Pay Taxes on Mutual Funds

Through mutual fund investments, it is possible to add hundreds of thousands of dollars in wealth to your bottom line over the long term. Taxes on your mutual fund investments, however, will subtract away from your total returns. Mutual fund tax ramifications are more so complicated, because you are buying into an investment pool where a fund manager trades securities at his own discretion. You are therefore responsible for paying taxes on transactions that occur within the fund in the form of capital gains distributions, alongside the dividends and realized capital gains that you generate from owning and trading mutual funds.

Tax Paperwork

At tax season, your mutual fund company will submit 1099 forms to both the IRS and your address on record. You will reconcile 1099 information against your monthly mutual fund statements to summarize your investment activity. With mutual funds, you generally will be responsible for paying taxes on interest, capital gains distributions, dividends, and realized capital gains. You will attach Schedule D to Form 1040 to report mutual fund income to the IRS.

Taxes on Interest

Money market mutual funds and bond funds will generate large interest payments. You will report these payments as taxable interest on Form 1040. For the 2010 tax year, taxable interest is subject to ordinary income tax rates of 10, 15, 25, 28, 33, and 35 percent. The U.S. tax code is progressive, which means that your mutual fund interest will be taxed at higher rates as you make more money. As a single filer, you will enter the 35 percent tax bracket when you report at least $373,650 in taxable income for the year.

Taxes on Mutual Fund Dividends

Mutual fund dividends will be categorized into qualified and ordinary dividends on your 1099. Ordinary dividends are taxed as ordinary income. Alternatively, qualified dividends are either tax free or taxed at maximum 15 percent rates. For qualified dividends, your fund manager must own shares of stock for at least 61 days out of the 120-day holding period surrounding their ex-dividend date. The fund manager buys and holds stocks prior to and through the ex-dividend date, in order for you to receive dividends on the next payable date.

Taxes on Capital Gains Distributions

Capital gains distributions occur when your fund manager sells investments within the fund at a profit. You will be responsible for paying taxes on these distributions as long-term capital gains. Long-term capital gains are either tax free or taxed at 15 percent rates. Be advised that you may be responsible for paying taxes on capital gains distributions, even if your overall mutual fund investment is losing money. Under this scenario, the fund manager may have sold some winning stocks, but continues to hold onto investments that are failing to perform.

Realized Capital Gains

For tax purposes, capital gains are classified as either short or long-term capital gains. Short-term capital gains are taxed as ordinary income, while long-term capital gains are again, either tax free or taxed at 15 percent. When calculating capital gains taxes, you must remember to subtract away any prior capital gains distributions from your sales proceeds. For example, you may purchase Mutual Fund Z at $25 per share and hold it for three years, before selling out your position at $45 per share. During this time, you were responsible for paying taxes on $5 worth of capital gains distributions. You would then owe taxes on $15 worth of long-term capital gains ($45 - $25 = $20 - $5 capital gains distributions = $15).

Realized Capital Losses

If your mutual fund investments fail to perform, you can write off $3,000 worth of realized capital losses from your taxable income. Losses that exceed the $3,000 limit can be carried forward to be deducted in subsequent years. Be advised that the IRS prohibits wash sales for the sole purpose of taking a tax write off. A wash sale occurs when you sell a mutual fund and immediately buy it back within 30 days.

How to Pay Taxes on Mutual Funds, Sources:

SEC: Invest Wisely - Mutual Funds

IRS: Mutual Fund Distributions

IRS: Capital Gains and Losses

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