You may owe tax on mutual funds you’ve invested in — even if you haven’t sold any of the shares or received any cash from your investments. Here’s an overview of how and when you pay tax on mutual funds, plus six things you can do to pay less tax.
Tax on mutual funds while you own the shares
A mutual fund combines 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 those shares can rise or fall depending on how the underlying securities in the mutual fund perform.
Two things can happen while you own your mutual fund that might generate a tax bill:
- Your mutual fund might give you your share of the dividends or interest that the underlying securities paid during the year.
- The mutual fund manager might sell some of the securities in the fund for a profit and then give you your share of that profit.
IRS Publication 550 has the details on the tax rules for investment income and expenses.
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 or automatically reinvested into the mutual fund. If you opt to reinvest your dividends, the IRS generally still considers that money taxable.
- Mutual funds that invest in bonds might receive interest payments from those 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 tax-free.
- If your mutual fund distributes dividends or interest during the year, you’ll probably get an IRS Form 1099-DIV or 1099-INT the following January showing how much you received from the fund. You’ll use the form to report the income on your tax return. Don’t ignore these forms. The sender gives a copy to the IRS, so the IRS is probably going to notice if you don’t report the income.
Tax on mutual funds if the fund managers generate capital gains
- 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.
- You’ll probably get an IRS Form 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.
- Again, don’t ignore your 1099-DIV; the IRS is going to get a copy, and sooner or later it will probably realize if you don’t report the income.
- Your tax on capital gains earned while you still own shares of the mutual fund depends in part on how long the fund held the investments.
Tax on mutual funds when you sell
Because a mutual fund invests your money in a variety of assets such as stocks and bonds, the value of your mutual fund’s shares — and your investment — can rise or fall depending on how those underlying securities perform. That can lead to taxes when you sell.
- 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. Capital gains are 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.
- There are a few different methods for determining exactly which shares you’re selling and how much profit you’re making. In a nutshell, you can specify the exact shares you’re selling, sell the oldest shares first or use the average cost of all the shares you own. The choice is important because it can influence how you calculate your profit and how much tax you might owe.
- How long you own 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.
6 quick tips to minimize the tax on mutual funds
- Wait as long as you can to sell. Selling in less than a year can trigger higher capital gains taxes if you make a profit.
- Buy mutual fund shares through your traditional IRA or Roth IRA. If you put money in a traditional IRA account, 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 your 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. There are other ways to minimize your mutual fund taxes, too, so find a qualified tax pro and discuss your options.