Taxes on Mutual Funds: How to Calculate, Strategies to Save
You may owe tax on mutual funds, even if you haven’t sold your shares. Here's an overview of how taxes on mutual funds work, plus strategies to minimize what you owe.
Many, or all, of the products featured on this page are from our advertising partners who compensate us when you take certain actions on our website or click to take an action on their website. However, this does not influence our evaluations. Our opinions are our own. Here is a list of our partners and here's how we make money.
You can incur taxes on mutual funds when you receive dividends, interest or capital gains and when you sell your shares of mutual funds at a profit. Tax on mutual funds ranges from 0% to 37% and depends on whether the distribution is dividends, interest or capital gains, as well as several other factors.
A mutual fund pools money from many investors and invests it in assets such as stocks and bonds. Professionals manage the mutual fund and decide when to buy and sell stocks, bonds or other assets in the portfolio. The investors own shares of the mutual fund and pay an annual fee to cover the cost of operating the fund. The value of the mutual fund shares can rise or fall depending on how the underlying securities in the mutual fund perform.
Taxes on mutual fund distributions and capital gains
Generally, two things can trigger a tax bill while you own shares of mutual funds: dividends or interest paid to you from the fund, and profits on securities sold by your fund manager.
1. Tax on mutual funds if you get dividends or interest
Dividends are usually taxable income.
When you invest in a mutual fund, you usually get to choose whether you want your share of the dividends distributed to you in cash or automatically used to buy more shares of the mutual fund. If you opt to reinvest your dividends, the IRS generally still considers that money taxable.
Dividends can be ordinary or qualified. Ordinary dividends are taxed at your regular income tax rate, which could be as high as 37% depending on which tax bracket you’re in. Qualified dividends are taxed at either 0%, 15% or 20%, depending on taxable income and filing status.
Mutual funds might receive interest payments from bond investments. Your portion of that interest may also be taxable income, even if you reinvest it. The interest on some bonds, including municipal bonds and U.S. Treasurys, may be fully or partially tax-free.
You’ll probably get an IRS Form 1099-DIV or 1099-INT the following January showing how much dividend or interest income you received. You’ll use the 1099s to report the income on your tax return.
Don’t ignore 1099s. The sender gives a copy to the IRS, so the government will know if you don’t report the income.
NerdWallet Wealth Partners can create a personalized plan that evolves with you, from this tax season to the next chapter. Start by answering a few questions.
on NerdWallet Wealth Partners' site. For informational purposes only. NerdWallet Wealth Partners does not provide tax or legal advice.
2. Tax on capital gains inside the fund
If the mutual fund’s managers sell securities in the fund for a profit, the IRS will probably consider your share of that profit a capital gain. Generally, mutual funds distribute these net capital gains to investors once a year.
Capital gains are taxable income, even if you reinvested the money in more mutual fund shares.
You’ll probably get a 1099-DIV in January showing your portion of the fund’s capital gains during the previous year. You’ll need this form to report your capital gain on your tax return.
The amount of capital gains tax you may owe depends in part on how long the fund held the investments.
Taxes on mutual funds when you sell
The value of your mutual fund shares can rise or fall depending on how those underlying securities perform.
You might sell your mutual fund shares for more than you paid or for more than the cost basis. (That’s usually the goal.) That profit is a capital gain, which is taxable income.
If you’re like most people and bought your mutual fund shares a little at a time, you probably own a bunch of mutual fund shares that you purchased at various prices. Specifying the exact shares you’re selling is important because it can influence how you calculate your profit and how much tax you might owe.
How long you owned your mutual fund shares also matters. If you owned them for more than a year before selling, your capital gains tax rate may be lower.
When do you pay taxes on mutual funds?
You report income generated from a mutual fund in April when you file your annual tax return. This is true whether the income was from dividends, interest or capital gains. You may need to pay quarterly estimated taxes if you suspect your regular withholding may not cover your tax liability. IRS Publication 550 has the rules for investment income and expenses.
A good financial advisor should guide you through the process of reporting this income and tell you which forms and schedules you'll need to file alongside your 1040.
The more you earn, the more complex your taxes become. Learn the 10 traps to dodge.
on NerdWallet Wealth Partners' site. For informational purposes only. NerdWallet Wealth Partners does not provide tax or legal advice.
6 ways to minimize taxes on mutual funds
Wait as long as you can to sell. Selling mutual fund shares that you’ve held for less than a year can trigger a higher capital gains tax rate on the profit.
Buy mutual fund shares through a traditional IRA or Roth IRA. If you put money in a traditional IRA, your investments grow tax-deferred; you’re not taxed until you withdraw money. If you put money in a Roth IRA, there are no taxes on investment growth, interest or dividends if you withdraw them after age 59 ½ and have the IRA for at least five years.
Buy mutual fund shares through a 401(k) account. If you put money in a traditional 401(k) account, taxes are deferred until you withdraw the money.
Know what kinds of investments the fund makes. If you don’t want a lot of taxable dividends headed your way every year, for example, then you may not want to invest in a mutual fund that owns a lot of dividend-paying stocks. If you don’t want a lot of taxable capital gains distributions hitting you while you own the shares, then you might favor index funds, which tend to buy and sell their underlying investments infrequently.
Use tax-loss harvesting. If your investments are in a taxable account, you might be able to offset some taxes by selling other underperforming mutual funds or securities at a loss. Those losses can offset some or all of your investment gains.
See a tax professional. A financial advisor can discuss other options for minimizing your mutual fund taxes.