Mutual Funds and The New Tax Laws

Changes a few years back (now set to expire in 2012) in the US tax code reduced the tax rate on dividends. Mutual fund investors know that their funds pay dividends, but that doesn’t necessarily mean your fund dividends will now be non-taxable or even get much of a tax break. On the contrary, depending upon the type of fund you own, your tax liability may barely change. Let me explain.

As it stands now, corporations pay income taxes on their profits, and until the law passed, if they then paid out a dividend to their shareholders, that dividend would be subjected to income taxes too. That's double taxation. To ease the burden of the shareholder, the shareholder pays the the "second "tax" at a maximum rate of 15% (through 2012). This paragraph applies to dividends you receive from holding shares in an individual company.

Mutual fund dividends are different as they have several possible components to them. If your fund owns stocks, and some of those stocks pay dividends, that portion of your fund dividend that represents true stock dividends will taxed at a maximum of 15% (provided they are "qualifying dividends" and we will skip the technical explanation here). However, for most mutual funds, dividend income is not a major portion of the fund dividend that is paid out to shareholders.

Mutual funds also include capital gains distributions, both long and short term, as part of their regular dividend. These capital gain distributions make up most of the dividends declared. A third component of a fund dividend is interest from securities, such as bonds, that pay interest. Interest is not a dividend and is still subject to being taxed as regular income (rates as high as 35% in 2012).

Thus it is possible to have a mutual fund dividend comprised of stock dividends, interest, short and long term capital gains. You will need to keep track of these different types of income for your income taxes (the fund breaks down the allocation for you on the 1099 they send you each year), and for when it is time to ascertain your cost basis for shares sold. Each component is taxed differently (in 2012):

qualifying stock dividends taxed at a maximum of 15% (possibly less for low-bracket tax payers)
interest is taxed as ordinary income, just like any other income
long term capital gains are taxed at a maximum of 15%, the same as qualifying dividends
short term capital gains are taxed as ordinary income

Even with the above seemingly-confusing explanation of how a mutual fund dividend is taxed, we have simplified and spared you some complications.

One way to simplify this for yourself is to hold your mutual funds in either a qualified account (retirement account or pension), and IRA or to purchase a variable or fixed annuity. By using these devices, all of the income when taken out is taxed as ordinary income.

If you like the idea of the 15% top rate on dividends and long term capital gains, it is simpler (fort tax purposes) to buy shares of individual companies rather than to hold shares through a mutual fund. But get ready because it is likely that Congress will change all of the above for years after 2012.