Mutual Fund Tax FAQ

Mutual fund taxes come primarily from dividends and capital gains when funds are held in taxable accounts. There are also taxes due on distributions from qualified retirement accounts, such as 401(k) plans and IRAs. Learn the basics of mutual fund taxation before buying or selling funds, and definitely before filing your annual tax return.

How Account Type Affects Taxes

There are three primary types of investment accounts.

Taxable Accounts

Taxable accounts are funded with after-tax dollars. The income, such as dividends and interest, is taxable to the investor in the year it's earned. Earnings or gains are additionally taxed when the investments are sold. Examples of these accounts include individual brokerage accounts, joint brokerage accounts, and most savings accounts at banks.

Tax-Deferred Accounts

Tax-deferred accounts are funded with pre-tax dollars. The earnings or growth of the investments held within the account aren't taxed as long as the investments remain in the account. Examples include IRAs, 401(k)s, and annuities.

Tax-Exempt Accounts

Tax-exempt accounts are accounts funded with after-tax dollars, where the returns grow tax free. Roth IRAs and Roth 401(k)s are examples of tax-exempt accounts.

How Are Dividends Taxed?

Dividends are payments to shareholders (investors) of stocks, bonds, or mutual funds. These payments represent a company's profit that's divided among the shareholders. Mutual fund investors choose whether they want their dividends to be reinvested to buy more shares of the fund, or to be received as a cash payment or deposited into another account.

Mutual fund shareholders can be taxed on a fund’s dividends, even if these distributions are received in cash or reinvested in additional shares of the fund. Mutual fund dividends are generally taxed either as ordinary income at the individual's income tax rate, or as qualified dividends, which are taxable up to a 15% maximum rate.

Ordinary and qualified dividends are reported to mutual fund investors on Form 1099-DIV. The mutual investor taxpayer reports dividends on line 1a of Form 1099-DIV and line 3b of the 2022 Form 1040.

What Do I Do With My 1099 Form?

There are numerous types of 1099 forms. Several are generated from investing activities, such as dividends, capital gains, and IRA, 401k, and 403b distributions. The most common types of 1099's received by investors include 1099-R, 1099-DIV, 1099-INT and 1099-Q.

These forms are generally sent to both the IRS and to the individual taxpayer by the institution that distributed the dividend, capital gain, interest, or cash withdrawal. It's not required that a taxpayer send their copy to the IRS with their tax filing, but you should retain your 1099s and other documents that provide supportive evidence of your taxable and non-taxable activities.

Form 1099-R

Form 1099-R is required to be sent to you by the custodian of a retirement account, such as an IRA, annuity, pension, profit-sharing plan, or 401(k) plan, if you've had a distribution of some kind during the tax year. Keep in mind that a distribution doesn't necessarily mean a cash withdrawal. It simply means that money was moved out of the account. Examples of distributions include a partial or full cash withdrawal or an IRA rollover.

Form 1099-DIV

Form 1099-DIV is sent to an investor from a mutual fund company to show a record of all dividends and capital gains paid to the investor during the tax year. Some investors can be confused by Form 1099-DIV because they might not have received any form of cash payment from dividends or capital gains during the year.

You're still considered to have received the dividends even if you choose to reinvest them. You can still have capital gains even if you haven't actually sold shares of your mutual fund.

Form 1099-INT

Form 1099-INT is sent by institutions, such as banks, to account holders who have received interest payments of at least $10 during the tax year. Interest shouldn't be confused with dividends. It's most commonly earned in bank savings accounts, certificates of deposit, and money market accounts.

Form 1099-Q

Form 1099-Q is sent to investors who received a distribution from a Coverdell Education Savings Account (ESA) or Section 529 Plan. Taxpayers generally don't have to pay taxes on distributions that are less than or equal to qualified education expenses.

What Is Form 5498?

Form 5498 is a tax document that's issued to holders of tax-deferred accounts, such as traditional IRAs, SEP-IRAs, or SIMPLE IRAs. The form is sent by the financial institution where you hold your account, and a copy is sent to the IRS. You don't have to send your Form 5498 to the IRS with your annual Form 1040 tax filing.

Form 5498 is for informational purposes, and it includes contribution amounts you made, the fair market value as of the end of the tax year, and information on taking required minimum distributions. Your 5498 should be mailed to you by Jan. 31 of the year following the tax year, along with your 1099-R.

How Do I Calculate Average Basis on Mutual Funds?

You must calculate the average basis when you acquire mutual fund shares at various times and prices. You can do this by adding up the cost of all the shares you own in the fund. Divide that result by the total number of shares you own. This gives you your average per share. Multiply the average per share by the number of shares sold.

You can no longer use the double-category method for figuring your average basis.

What Is Net Unrealized Appreciation (NUA)?

Net unrealized appreciation (NUA) can occur when you withdraw company stock from your 401(k) and move it into a taxable brokerage account.

The NUA is important if you have company stock that's appreciated significantly, and you're transferring the stock from a tax-deferred employee-sponsored retirement plan, such as a 401(k). Distributions like this are typically allowed only when you have a triggering event, such as retirement or termination of employment.

The NUA isn't subject to ordinary income tax at the time of the distribution, so it can be smart to do the transfer of company stock into a regular brokerage account rather than another tax-deferred savings vehicle, such as an IRA.

Any gain on your shares will be taxed when you decide to sell the shares at long-term capital-gains rates, which can be as low as 0%. But all withdrawals are taxed at ordinary income rates if you roll your company stock into an IRA, which can be as high as 37%, plus a 10% penalty if you're under the age of 59½.

How Can I Avoid Double Taxation?

Mutual funds aren't the same as other investment securities, such as stocks, because they're single portfolios, called "pooled investments," that hold dozens or hundreds of other securities. There are added complexities that can create a form of double taxation for this reason.

The taxable activity that takes place as part of mutual fund management passes along tax liability to you, the investor. You'll owe tax on two levels if a stock holding in your mutual fund pays dividends, then the fund manager later sells the stock at a higher value than they paid for it: a dividend tax, which is generally taxed as income, and a capital gains tax, which is taxed at capital gains rates.

It's possible that you could receive a long-term capital gain distribution even if you've only held the mutual fund for a few months and haven't sold any shares, assuming the mutual fund held the stock for more than a year. The taxes distributed to you are due to the activities within the mutual fund, not your own investing activities.

How Do I Reduce Taxes?

Taxation is significantly different in tax-deferred accounts than how it's handled in brokerage accounts. Selling mutual funds in a tax-deferred account, such as an IRA or 401(k), won't generate capital gains taxes. In fact, selling funds generates no taxes at all, although other mutual fund fees might apply. And income from dividends isn't taxed in IRAs or 401(k)s until it's withdrawn.

Remember that investments held in a brokerage account are taxed on capital gains and on interest income or dividends. You'll have a capital gain for which you'll owe a tax if you sell a mutual fund at a price (NAV) higher than the price for which you purchased it. Any interest income or dividends earned on investments in a brokerage account will be taxed as ordinary income, just as if you received pay from an employer.

You can minimize taxes when it's possible and appropriate for your investment objectives by keeping your income-generating investments, such as bond funds and dividend-producing stock funds, in your 401(k) or IRA. Keep your tax-efficient funds, such as growth stock funds, small-cap stock funds, index funds, and ETFs, in your taxable brokerage account.

What Is Tax Cost Ratio, and How Do I Find It?

The tax cost ratio measures the amount of annualized return an investor loses to taxes. An investor's net return after taxes is 8% if a mutual fund's tax cost ratio is 2% and the return of the fund is 10%. Look for low tax cost ratios to find tax-efficient funds.

Morningstar is a mutual fund research and analysis company that calculates and provides tax cost ratio:

• Go to Morningstar.com.
• Enter the ticker symbol at the top of the page. It will take you to the fund's "quote" page. 
• Click on the "Tax" link on the toolbar beneath the fund name. You'll find the tax cost ratio on this page.

Frequently Asked Questions (FAQs)

The information on this site is provided for discussion purposes only and should not be misconstrued as tax advice or investment advice. Contact a tax professional for the best guidance on your tax circumstances. Under no circumstances does this information represent a recommendation to buy or sell securities.