Understanding Taxes on Mutual Funds Dividends

Many people choose to invest in dividend-bearing mutual funds as a way to generate regular income throughout the year. While this can be a simple and effective way to augment your regular earnings, it is important to understand the tax implications of dividend income from mutual funds.

A mutual fund pays dividend distributions when assets in its portfolio pay dividends or interest. Most commonly, dividend distributions are the result of dividend-bearing stocks or interest-bearing bonds. Not all funds pay dividends. However, mutual funds are required to distribute all net profits each year to avoid paying income taxes on those earnings. A fund that receives interest or dividend income from stocks or bonds must make at least one dividend distribution per year. If your mutual fund distributes dividends or capital gains in a given year, this income is reported to you on Form 1099-DIV.

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

When an individual company turns a profit, it can elect to retain those earnings, reinvest them into the company by funding growth or distribute them to shareholders in the form of a dividend. In the stock market, consistently paying dividends each year is considered a sign 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 rather of the types of investments in its portfolio.

In addition to dividend-bearing stocks, mutual fund dividends can be the result of interest-bearing bonds. Most bonds pay a set amount of interest each year, called a coupon rate. The coupon is simply a percentage of the bond's par value and may be paid monthly, quarterly, semi-annually or annually. Dividends are paid to shareholders according to their holdings. Thus, a fund that announces a 50 cent dividend per share pays $50 to an investor who owns 100 shares.

Mutual funds and individual stocks that pay dividends are popular investments. However, earning dividends is a matter of timing. When a company declares a dividend, it also announces the ex-dividend date and date of record. The date of record is the date on which the company reviews its list of shareholders who will receive the dividend payment. Because there is a time delay when trading stocks, any sale of shares that occurs fewer than three days prior to the date of record is not registered, and the list of shareholders still includes the name of the selling investor.

The date three days prior to the date of record is the ex-dividend date. An investor who sells his shares on or after the ex-dividend date still receives the dividend despite the fact he no longer owns shares by the time the dividend is paid. Similarly, any share purchase made after the ex-dividend date is not eligible for the dividend. The same rules that apply to the receipt of stock dividends also apply to mutual funds. To receive payment, an investor must own shares in the fund prior to the ex-dividend date.

In general, dividends paid by a stock or mutual fund are considered ordinary income and are subject to your normal income tax rate. If your mutual fund buys and sells dividend stocks often, more than likely any dividends you receive are taxed as ordinary income. For example, assume you receive $1,000 in dividend payments from your actively managed fund. If you are in the 25% income tax bracket, you pay $250 at tax time.

Minimizing your investment tax burden is primarily a matter of generating long-term gains rather than short-term income. This means holding investments for long periods of time, generally more than one year.

Income from investments held longer than a year is subject to the capital gains tax, which can be substantially lower than your ordinary income tax bracket. In fact, for those in the 10 and 15% brackets, the capital gains tax rate is 0%. If your annual income is low enough, you may be able to earn long-term investment income tax-free. For those in the 25 to 35% brackets, the capital gains tax rate is 15%. For the highest earners, the capital gains tax is 20% rather than their ordinary income tax rate of 39.6%.

Because the difference between these two tax rates is so significant, at up to 20%, employing a buy-and-hold strategy has some very real tax benefits.

Though most dividends are considered ordinary income, dividends considered "qualified" by the IRS are subject to the lower capital gains tax. The primary requirement for qualified dividends is the dividend-bearing stock must be held for a certain amount of time, called the holding period. When it comes to 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.

For a mutual fund dividend to be considered qualified, it must be the result of a dividend payment by a stock in the fund's portfolio that meets the holding requirement outlined by the IRS. The fund must have owned the stock for at least 60 days within the 121-day period that starts 60 days prior to the ex-dividend date. This may sound confusing, but essentially it means the fund must own 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 buying and selling stocks just to get the dividend.

If a mutual fund issues a dividend distribution as a result of interest earned on bonds, then that income is generally subject to your ordinary income tax rate. In some cases, mutual fund dividend payments may not be subject to any federal income tax. This only occurs if the dividend is the result of interest payments from government or municipal bonds. Some funds invest exclusively in this type of security, often called tax-free funds.

While earnings from municipal bonds 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. To be properly prepared for tax season, it is important to know which assets are generating dividends and how the different tax rates apply to different types of dividend income.