A Beginner's Guide to Mutual Fund Distributions
Learn About the Three Types of Mutual Fund Distributions
A mutual fund is a security that allows investors to pool their capital into one professionally managed investment portfolio. If mutual funds are part of your investment portfolio, then it's important to understand how distributions from those funds work.
A mutual fund distribution represents a share of the earnings from the fund's operation, and differ in how they can return profits to shareholders.
Unlike an individual company—who might choose to retain the profits or return it to shareholders in the form of a dividend or through share buybacks—a mutual fund is required by law to pass profits back to its investors, or shareholders.
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. Understanding the distinctions between the various mutual fund distribution types is important, particularly for tax purposes.
- Mutual funds are required to distribute net capital gains and accrued income to shareholders at least annually.
- You're responsible for reporting mutual fund distributions on your tax return.
- Mutual fund distributions can take one of three forms.
- Certain mutual fund distributions can receive more favorable tax treatment than others.
How Ordinary Dividends Work
Ordinary dividends represent the mutual fund income that is not from 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 at the investor's ordinary income tax rate. That means ordinary dividends are essentially treated the same as income earned from working for tax purposes.
What Are 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 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—they must be paid by a U.S. corporation or a qualified foreign corporation. Also, 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 ex-dividend date is the first date following the declaration of a dividend and indicates the cut-off date when the buyer of the stock will not receive the next dividend payment. Instead, the seller will receive the dividend payment. Otherwise, the dividend will be taxed at the ordinary income tax rate.
Capital Gains and Mutual Fund Distributions
For a mutual fund, the capital gain is the profit made from selling securities in its holdings. This capital gain 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 a short-term capital gain. It 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 considered. The most common 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 the 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.
The Bottom Line
Mutual fund distributions can provide income in your portfolio, but it's important to understand how they work. Knowing the difference between various mutual fund distribution options can help you minimize your tax liability each year.