Understanding Taxes on Mutual Funds Dividends

Many people invest in dividend-bearing mutual funds to generate additional income. While this can be simple and effective in increasing your regular earnings, it's important to understand the tax implications of mutual fund dividends long before the next tax season arrives.

Mutual funds must distribute almost all their net income and realized capital gains to their shareholders annually. These distributions, also called dividends, can cause confusion at tax time. The Internal Revenue Service (IRS) treats ordinary dividends, qualified dividends, and capital gains distributions differently.

In this article, we'll guide you through the different types of distributions and their tax implications.

When Does a Mutual Fund Pay Dividends?

A mutual fund pays distributions when assets in its portfolio pay dividends or interest. Most often, these result from dividend-bearing stocks or interest-bearing bonds.

However, not all mutual funds pay dividends. Some funds, such as growth equity funds, prioritize capital appreciation over income generation and may not have dividends from the companies to distribute. Nonetheless, mutual funds are legally obligated to distribute all net profits to their shareholders annually to maintain their tax-exempt status. Failure to do so would result in the fund being taxed on those earnings.

For funds that receive interest or dividend income from their holdings, the law mandates that they make at least one dividend distribution per year. These distributions are reported to investors on Form 1099-DIV. This tax document outlines the various types of income received from the fund, including ordinary dividends, qualified dividends, and capital gains distributions.

Understanding Mutual Fund Dividends

A dividend is the share of profits given to the shareholders. The difference between a mutual fund dividend and a stock dividend is that one from a fund is generated by underlying assets, while stock dividends result from profitable operations.

When an individual company turns a profit, it can retain those earnings, reinvest them into the company, or distribute them to shareholders as a dividend. In the stock market, consistently paying dividends each year is a signal of the issuing company's financial health.

Mutual funds are pass-through investments, meaning any dividend income they receive must be distributed to shareholders. Therefore, a dividend payment is not indicative of the health or success of a given fund but of the types of investments in its portfolio. The success of a mutual fund lies in its total return, which includes price appreciation and dividend payments.

Fund dividends can also result from interest-bearing bonds. Most bonds pay a set amount of interest, the coupon rate. Dividends are paid to shareholders according to their holdings. Thus, a fund that announces a $0.50 dividend per share would pay $50 to an investor with 100 shares.

Earning Dividends

When a mutual fund declares a dividend distribution, it also announces the ex-dividend date and the date of record—that's when the fund reviews its list of shareholders eligible to receive the dividend payment.

However, because of the time delay in processing trades, any sale of mutual fund shares that occurs fewer than one business day before the date of record may not be registered in time, and the selling investor's name may still appear on the list of shareholders. To address this issue, mutual funds set an ex-dividend date, typically one business day before the date of record. Investors who sell their mutual fund shares on or after the ex-dividend date still get the dividend payment, even if they no longer hold the shares by the time the dividend is paid.

Meanwhile, investors who buy mutual fund shares after the ex-dividend date are not eligible for the upcoming dividend distribution. To qualify for the dividend, investors must own shares in the mutual fund before the ex-dividend date.

Investors should pay attention to these critical dates when considering the timing of their mutual fund transactions. Those who wish to receive a particular dividend distribution should ensure they have bought shares before the ex-dividend date. However, investors planning to sell their shares and are less concerned about receiving the upcoming dividend may wait until on or after the ex-dividend date to execute their sale.

Ordinary Dividends

Generally, dividends paid by a stock or mutual fund are considered ordinary income and subject to your regular income tax rate. If a mutual fund issues a dividend distribution due to interest earned on bonds, then that income is generally subject to your ordinary income tax rate. Also, if your mutual fund buys and sells dividend stocks often, your dividends will likely be taxed as ordinary income.

For example, suppose you receive $1,000 in dividend payments from your actively managed fund. If you are in the 25% income tax bracket, you would pay $250 at tax time.

Capital Gains Tax

Minimizing your taxes involves strategies for dealing with different rates between generating long-term capital gains and recurring income like dividends. Holding investments for more than one year generally qualifies any gains from the sale of those investments as long-term capital gains, which are taxed at lower rates than short-term capital gains.

Long-term capital gains tax rates are substantially lower than ordinary income tax rates, which apply to short-term gains and ordinary dividends. For single filers or married individuals filing separately, the long-term capital gains tax rate is 0% for those who earn less than $40,400 annually. For married couples filing jointly, this 0% rate applies to incomes up to $80,800. Above these thresholds, the rate steps up to 15%, and for the highest-income earners, it can reach 20%.

If you've just bought shares in a mutual fund, whether the dividends you receive are classified as ordinary or qualified depends not on the duration you've held the mutual fund shares but on how long the mutual fund has held the stocks that generated these dividends. If the mutual fund passes along dividends from stocks it held long enough to meet the qualified dividend criteria, and you meet the holding period requirement, these dividends can be taxed as qualified dividends.

Mutual funds report these dividends on Form 1099-DIV, distinguishing between ordinary dividends (Box 1a) and qualified dividends (Box 1b). This form will help you understand how much of your dividend income qualifies for the lower tax rate.

Qualified Dividends

Though most dividends are considered ordinary income, dividends considered "qualified" by the IRS are subject to a lower tax rate. The primary requirement for qualified dividends is that the dividend-bearing stock be held for a certain amount of time, which is called the holding period. For mutual fund dividends, the holding period refers to the length of time the fund has owned the stock rather than how long you have owned shares in the fund.

To be considered qualified, a mutual fund distribution must come from the dividend payments of stocks in the fund's portfolio that meet specific IRS requirements. The fund must have owned the stock for either 60 days before the ex-dividend date or a combination of days before and after that add up to at least 60 days. This regulation is in place to discourage funds and individual investors from trading stocks to get dividends.

Tax-Free Dividends

Mutual fund dividends are sometimes not subject to federal income tax. This only occurs if the dividend is the result of interest payments from the government or municipal bonds. Some funds invest only in this type of security, often called tax-free funds.

While municipal bond earnings are not subject to federal income tax, they may still be subject to state or local income taxes. Bonds issued in your state of residence may be triple-tax-free, meaning interest payments are not subject to any income taxes. Investing in dividend-bearing mutual funds can be a great source of regular income. It's important to know which assets generate dividends and how the different tax rates apply to various types of dividend income.

The Bottom Line

Dividends paid by mutual funds can be classified as ordinary or qualified dividends, which are taxed at different rates. Ordinary dividends are taxed at the investor's regular income tax rate. Meanwhile, qualified dividends have lower capital gains tax rates of 0%, 15%, or 20%, depending on your overall income. Investors in mutual funds should be aware of these distinctions and plan their investment strategies accordingly to manage their tax liabilities effectively. Seeking the advice of a tax professional is always prudent to understand the specific tax implications for your situation.