Understanding the Tax Consequences of Mutual Fund Ownership

Many federal employees invest in mutual funds in non-retirement brokerage accounts. They invest directly with a mutual fund company or through a securities brokerage firm, including a bank or credit union offering brokerage services.

Investing in mutual funds in non-retirement accounts most likely has tax consequences. Many investors have questions as to how to report on their federal income tax return the income they receive from mutual fund distributions and how these distributions are taxed.

As federal employees start to prepare their 2020 federal income tax returns, this column will assist employees who own mutual funds as to how to enter on their federal income tax return any mutual fund distributions they received during 2020.

As a rule, most mutual fund distributions paid to the mutual fund owner is declared as investment income on the fund owner’s yearly income tax return and subject to either “ordinary” income tax or to the “preferential” long-term capital gains tax.

The “type” of fund distribution received, and the “duration” of the underlying investment held by the mutual fund are important factors in determining how much income tax the mutual fund owner will pay on each dollar of a fund distribution.

In some cases, mutual fund distributions are subject to “ordinary” income tax rates (the higher tax rates), while in other cases the fund owner may be eligible to pay the lower (“preferential”) long-term capital gains tax rate. In some cases, mutual fund distributions are 100 percent tax-free.

The following is some general information with respect to mutual fund distributions:

· Fund distributions are generally taxable, subject to either ordinary income tax rates or preferential long-term capital gain tax rates. The difference between ordinary income and long -term capital gains tax rates is based on how long that fund has held an individual investment security (a stock or a bond) within its portfolio.

· For a fund owner who receives a distribution from a fund that resulted from the sale of an underlying security which the fund held for less than a year, the rule is that distribution is taxed at the fund owner’s ordinary income tax rate. If the fund held the security for more than one year, then the fund distribution is subject to the lower long term capital gains tax rate.

· Mutual fund distributions created as a result of short-term capital gains (underlying securities held less than one year and sold at a gain) and distributed to the fund owner are taxed at ordinary tax rates.

Ordinary income versus long-term capital gain income

The difference between ordinary income and capital gains income can make a big difference in an investor’s tax bill. Only investments held for more than one year will be eligible for the preferential long-term capital gains tax treatment. This concept in differentiating tax rates is easy to understand when it comes to investing in individual stocks or bonds. But the investment world of mutual funds is more complicated.

Mutual funds are investment companies that invest the collective contributions of their investors (shareholders) in various stocks, bonds, or stocks and bonds called portfolios. When a mutual fund makes a distribution to its shareholders, the difference between ordinary income and capital gains has nothing to do with how long a fund investor has owned shares in the mutual fund. Instead, the difference depends on how long the fund has held an investment (stock, bond) within its portfolio.

If a fund investor receives a distribution from the fund that resulted from the sale of a security the fund held for less than a year, the fund investor will pay ordinary tax on that distribution. If the fund held the security for more than a year, the fund investor will pay the preferential long-term capital gains tax.

All fund distributions are formally reported annually to fund investors on Form 1099-DIV. Those federal employees and annuitants who invest in mutual funds and who received distributions in non-retirement accounts during 2020 should have received by now their 2020 1099-DIV statements from their mutual fund investment companies.

Difference between ordinary income tax and long-term capital gains tax

The difference between an individual’s ordinary tax rate and the individual’s corresponding long-term capital gains tax rate can be large.

The following table summarizes:

Mutual fund dividend distributions

In addition to distributing income generated by the sale of stocks and bonds, mutual funds also make dividend and interest distributions when the underlying stocks and bonds pay dividends and interest, respectively. Mutual funds are pass-through investments, which means any income they receive must be distributed to fund shareholders.

Taxation of mutual fund dividend distributions

In general, dividend distributions are taxed as ordinary income. If a mutual fund buys and sells dividend stocks often, then any income distributed as a result of the sale of the stocks will be considered short-term capital gains and taxed as ordinary income.

While dividends distributions are taxed mostly as ordinary income, there are two important exceptions, namely:

(1) qualified dividend distributions and

(2) nondividend distributions.

Qualified dividends distributions are distributions received from an individual’s mutual fund company and may be subject to the preferential long-term capital gains tax if the dividends are considered as qualified distributions by the IRS. To be considered a qualified distribution, the dividend must be paid by a stock issued by a U.S. or qualified foreign corporation.

The mutual fund also must have held the stock for more than 60 days within the 121-day-period date beginning 60 days before the ex-dividend date. The ex-dividend date is the date after which an owner of a newly purchased stock is ineligible for the dividend payment. If a stock’s ex-dividend date is February 24, then any investor who purchases the stock on or after February 24 is not eligible to receive the impending dividend.

A nondividend distribution is a payment to fund shareholders that is similar to a dividend but that represents a share of a company’s capital rather than its earnings. As such, it is nontaxable.

Reporting mutual fund distributions

Mutual fund companies report annually dividend distributions to their shareholders on Form 1099-DIV. Total dividends are reported in Box 1a of Form 1099-DIV, while qualified dividends are reported in Box 1b. Total capital gain distributions are reported in box 2a of Form 1099-DIV.

The mutual fund company will also report how much of the distribution is from unrecaptured Section 1250 gain (box 2b), Section 1202 gain (box 2c) or collectible gain (box 2d). Nondividend distributions are reported in Box 3 of Form 1099-DIV.

Total (ordinary) dividends are reported on Schedule B of one’s federal income tax while capital gain distributions are reported on Schedule D. There are separate calculations for ordinary dividends, qualified dividends and the various types of capital gains.

Additional information on the tax consequences of mutual fund ownership may be found in IRS Publication 550 (Investment Income and Expenses) which can be downloaded here.