WHICH DISTRIBUTIONS IN A MUTUAL FUND ARE NOT TAXED?
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The following are not taxed: return of capital, earnings inside qualified retirement plans, and (in most cases) the income from municipal bond funds and tax-exempt money market funds. Capital losses may be used as tax deductions.
Return of capital is the return of a part of your original investment to you. It is money that you invested into the fund. It is not shares that have been sold, and it is not dividend income. Returns of capital are not taxed because they are not income. However, if you receive a return of capital, your basis is lowered on all your shares. This can result in a higher capital gain when you redeem shares.
The ordinary earnings of qualified retirement plans are not currently taxed. To be qualified means to receive certain tax advantages. If you have a 401(k) plan, for example, the dividends that it receives are tax-exempt. This is an incentive for people to leave their money in their plans for very long periods. You will pay ordinary income taxes on all distributions from a qualified retirement plan.
Capital losses occur when you sell shares that have fallen in value to less than what you paid for them. For example, if you bought a share for $10 and later sold it for $8, you have a capital loss of $2 for that share. You are not taxed on capital losses. At present, you can deduct up to $3,000 in capital losses from your income. If you have a loss greater than $3,000, you may carry the excess over to future years until the loss is depleted.
The income from municipal bond funds and tax-free money market funds is usually not subject to federal taxes. This is because the securities these funds hold are almost never taxable on the federal level. Many of them are not taxable on the state level, either.
In addition to simply receiving income, there are actions you may take that will incur taxes. We will look at one of them next.