Distributions and Taxes

When a mutual fund makes a profit from the sale of investments in its portfolio, it generally passes the profit on to you in the form of capital gains. Long-term capital gains are gains on securities owned by the fund for more than one year.

A mutual fund earns dividends, interest and other investment income on the securities in which it invests. After a fund subtracts its expenses from the investment income, it distributes the remainder to you as an ordinary income distribution.

The IRS requires that ordinary income distributions include any short-term capital gains (gains on securities owned by the fund for one year or less) realized and distributed by the fund. That means, your short-term capital gains and ordinary income will appear combined in the same box on your tax form.

A special category called "qualified dividends" applies to dividends paid on stock investments. The mutual fund will pass through to investors any qualified dividends it receives from stocks in the fund's portfolio. Short-term capital gain amounts may also be categorized as qualified dividends.

Interest from state and local municipal bonds is exempt from federal taxes and generally is exempt from state taxes in the state in which the bonds were issued. Mutual funds that invest in these securities generally distribute tax-exempt dividends to their investors.

A return of capital distribution is not considered income, rather it is a return of your original investment dollars and is nontaxable.

Your tax bracket determines how much tax you will owe on long-term capital gain distributions, as shown in the table below.

This category also includes short-term capital gains. You will owe tax on these distributions at the rate of your ordinary income tax bracket.

Qualified dividends are taxed at the long-term capital gain rates, as shown in the table below.* They may also include short-term capital gains. To qualify for these reduced rates, you must own the mutual fund shares for a period of 61 days or longer. That period must include the date the fund distributed the dividends.

While the dividends may be tax exempt, a portion of the income may be an adjusting item for the Alternative Minimum Tax. It also is possible to have taxable capital gains from investing in tax-exempt bond funds since bond prices fluctuate in response to changing interest rates. By selling bonds at a profit, a fund can generate capital gain distributions that may be subject to federal and state income taxes.

Based on the income from investments from foreign corporations, the fund pays taxes to foreign governments. These taxes are passed through to individual investors, who can take a credit against their U.S. federal income tax provided they meet certain requirements. You may review the fund's annual report for information regarding the foreign tax calculation at the fund level.

Because this type of distribution is a return of your original investment dollars it is nontaxable. Your cost basis should be reduced by the same amount as the distribution.