A Beginner's Guide to Mutual Fund Distributions
Learn About the Three Types of Mutual Fund Distributions
Distributions from a mutual fund are simply earnings from the fund's operation. Unlike individual company who can choose either to retain the profit or return it to shareholders in the form of dividend or through share buyback, a mutual fund is required by law to pass profits back to its investors, or shareholders.
Remember: a mutual fund is a security that allows investors to pool their capital into one professionally managed investment portfolio.
There are many types of mutual funds with different objectives and guiding philosophies, but each must pass profits back to the investors in the form of mutual fund distributions, which can be in the form of any of these three distribution types:
- Ordinary Dividends
- Qualified Dividends
- Capital Gains
The distinctions between these mutual fund distribution types is important, particularly for tax purposes. Let's take a look at each of the distribution types.
1. Ordinary Dividends
Ordinary dividends represent the mutual fund income that is not from capital gains (see number 3 below for more information on capital gains). For a mutual fund, ordinary income is interest payment the fund received and distributed to investors as ordinary dividends. Ordinary income and dividends do not qualify for the qualified dividend definition and as such are taxed as the investor's ordinary income tax rate.
2. Qualified Dividends
According to the IRS definition, qualified dividends are:
"The ordinary dividends received in tax years beginning after 2002 that are subject to the same 5% or 20% maximum tax rate that applies to net capital gain."
Simply put, qualified dividends are dividends that meet certain criteria of the United States tax code and are therefore subject to a more favorable tax.
Rather than being taxed at the individual investor's income tax bracket rate, qualified dividends are taxed at what is known as the capital gains tax rate which currently has a maximum of 20%. For a comparison of the U.S. ordinary income tax rates versus capital gains tax rates, see the following chart:
|Investor's Ordinary Income Tax Rate||Ordinary Dividend Tax Rate||Qualified Dividend Tax Rate|
*These qualified dividend tax rates show a range in order to include the possible Net Investment Income tax of 3.8% that an investor may be subject to if their Modified Adjusted Gross Income (MAGI) if over the defined threshold. This tax is also known as the Medicare surtax.
For the dividend to be considered a qualified dividend rather than an ordinary dividend, the dividends must be paid by a U.S. corporation or a qualified foreign corporation and the mutual fund that holds the dividend-paying stock must have held the equity for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date (the first date following the declaration of a dividend on which the buyer of a stock will not receive the next dividend payment.
Instead, the seller will get the dividend). Otherwise, the dividend will be taxed at the ordinary income tax rate.
3. Capital Gains
For a mutual fund, capital gain is the profit made from selling a security in its holdings. This is the same profit an individual investor would make if they were to sell an individual stock at a price higher than what was originally paid for the stock. If the mutual fund (not the fund investor) has held the security for more than one year, the profit from the sale is treated as long-term capital gain, which is subject to a maximum of 20% tax rate for mutual fund shareholders (and follows the same favorable tax rates as a qualified dividend). On the other hand, if a stock is held in the mutual fund portfolio for less than a year, the profit realized by selling the stock will be treated as short-term capital gain and will be taxed at the fund investor's ordinary income tax rate just as ordinary dividends are.
Distributions and Mutual Fund Buying Strategy
When it comes to buying mutual funds, the tax implications of fund distributions must be taken into consideration. The most commonly made mistake in mutual fund investing is the so-called "buying-the-dividend," that is, buying mutual fund shares right before its dividend/capital gain distribution. When buying the dividend, the investor is responsible for paying current tax for the distribution. If you plan a large lump-sum investment in a mutual fund in your taxable account, you should check the fund's distribution schedule and adjust your buying plan accordingly to avoid buying-the-dividend.
However, this avoidance strategy should be put in perspective. According to The Mutual Fund Education Alliance:
"If the amount you're investing is fairly small, it's probably not worth waiting. And if you make regular investments every month, don't let buying the dividend derail your program. It's better to buy the dividend than to fail to invest."