WHAT INCOME IN A MUTUAL FUND IS TAXED?
The categories of taxable mutual fund income include ordinary dividends,
capital gains dividends, and capital gains on redemption of fund shares.
Ordinary dividends are dividends or interest passed on to
you from the holdings of a fund.
Funds pay these dividends monthly, quarterly, or semiannually.
Dividends are taxed at lower capital gains rates. If you reinvest
your dividends, they will still be taxed, unless they are part of certain retirement
Although municipal bond funds earn dividends that are usually federally
tax-free, their dividends may be taxable in your state if the bonds were issued
by another state.
A capital gain is the profit you earn when you redeem fund
shares that have risen in value.
It is important to remember that you only have capital gains after
you have sold your shares. While they are still in your hands, they are only
a profit on paper. Therefore, you are taxed on them only when they are sold.
Capital gains are either short-term or long-term. Short-term capital
gains are gains on shares that have been held twelve months or less. Long-term
gains require that the shares be held longer than twelve months. At present,
the tax rates on short-term gains are the same as the shareholder's income tax
bracket. Long-term capital gains rates are 15% for those in the 25 percent tax bracket
and above. Taxpayers in the 10 percent and 15 percent brackets will pay the
lower rate of 5 percent on capital gains and zero percent
in 2008. In 2009, unless Congress extends this new law, the capital gains rates
will revert to the prior 10 percent and 20 percent rates.
When a mutual fund sells shares of its holdings and earns a profit
on them, it passes its net profit on to its shareholders as a capital gains
dividend. You will be taxed at the short-term or the long-term rate depending
on how long the fund held the shares.
Now let us look at distributions that are not taxed.