Whether funds are withdrawn or reinvested in additional shares, there are going to be tax consequences to owning a mutual fund. There can even be taxable gains on a fund that has declined in value, so it is important to understand how investors make money in funds first, then figure out how withdrawals are taxed. This can save a lot of confusion, and maybe even some money, by avoiding buying a fund at the wrong time.
If your fund invests in bonds, or other interest bearing investments, the interest is passed through to shareholders as it is received. Although these are called dividends, they are treated as interest and taxed as ordinary income to the recipient. Shareholders will receive a 1099 showing the interest earned and it is reported on Schedule B when you file your taxes.
Two Classes of Dividends
Funds that invest in dividend paying stocks also pass through the dividends to shareholders. There are ordinary dividends, which are taxed at ordinary income rates, and qualified dividends, which are taxed at a maximum of 15 percent. If your tax bracket is less than 25 percent, there is no tax on qualified dividends. IRS Publication 17 lists the rules for qualified dividends, but the fund management company is responsible for reporting to shareholders how dividends are classified.
Capital Gains Distributions
Actively managed funds are constantly buying and selling shares throughout the year, taking gains and losses on investments. If there are more gains than losses, they must be distributed, usually at the end of the fund's fiscal year. The gains are reported to you on a 1099 and you report them on Schedule D when you file your taxes.
In highly volatile years, such as 2008, many funds have negative returns yet still have capital gains to distribute from stocks sold earlier in the year. Before investing in a fund, check when these distributions are scheduled. There is no benefit to buying shares just before a dividend. The share price declines by the value of the dividend and tje distribution is taxable regardless of how long you have held the fund.
Shareholder Capital Gains
If you have had a fund for many years, there may be gains embedded in the current share price. Any distributions received over the years, whether interest, dividends or capital gains, are added to your original cost basis. This reduces your gains, and the tax on them, when you sell your shares. Although most mutual fund companies will provide a detailed report if you request one, it is your responsibility to track the cost basis from year to year.
Taxes on Withdrawals
Withdrawals from funds are made by redeeming shares. These withdrawals are taxed based on the value of shares sold versus your cost basis. If you have no gains, there is no tax due. If you have a loss, it can be used to offset gains on other investments. You can also use up to $3,000 per year in losses to offset ordinary income. If you have gains, you can choose to be taxed based on the actual price of the shares that you sell. This requires a detailed record of purchases and distributions. Or you can use the average cost method, which averages your cost basis and is much easier to track. Your gains will be classified as long term if you have held the shares for more than one year.