Tax Tip Tuesday: Understanding Mutual Fund Distributions

Apr 11, 2023

By Ashlee Ogrzewalla, CFP®, Vice President and Manager of Financial Planning & Marketing
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Mutual funds continue to be one of the most popular tools investors use when creating a diversified portfolio. Mutual funds can have exposure to both domestic and global companies and markets, depending on which fund you select.

Major benefits of mutual funds are that they can offer diversification and active management by an investment professional. Mutual fund holders don’t risk owning a single security — instead, the diversification mutual funds offer helps limit big price swings or fluctuations with a typically lower buy-in than individual stocks.

Mutual funds may offer less upside than a single stock but have a lower downside. Like stocks, mutual funds pay dividends. However, unlike a stock, they may also distribute capital gains. This makes them less desirable to hold in a taxable account.

Capital gains distributions happen when securities within the fund are sold during the year. The fund will make a distribution if there are more gains than losses. Capital gains distributions are usually made just once, around the end of the year. In some cases, funds could be down in performance but still distribute capital gains and the taxpayer has no control.

Distributions are split into short-term and long-term gains. Short-term gains are those generated from securities held for less than one year, while long-term gains come from those held longer than one year. Long-term capital gains are taxed at the long-term capital gains rate, which can range from 0% to 20%, depending on the shareholder’s tax bracket. Short-term capital gains are taxable at the shareholder’s ordinary income tax rate, ranging from 10% to 37%.

Dividends apply to income received from stocks, mutual funds, index funds, and exchange-traded funds (ETFs). Dividends paid to mutual fund holders are classified as either qualified or ordinary income. Qualified distributions are taxed at capital gains tax rates. These distributions are taxable and are reported to shareholders on a 1099-DIV from their broker at the end of the year.

An ETF is a passively managed security and is very similar to a mutual fund. It is a group of stocks or bonds packaged as one security. ETFs trade like stocks. Likes some stocks and mutual funds, ETFs can pay dividends. These dividends are classified as qualified or ordinary. ETFs are more tax friendly than mutual funds because they don’t distribute capital gains, making them a very popular alternative to mutual funds.

The tax structure of different investment types can make investment selection challenging. It’s a good practice to check in with your advisor to understand how types of investments are taxed and which account type is most suitable for investments you are considering adding to your portfolio.

 

Benjamin F. Edwards does not provide legal or tax advice, therefore it is also important to consult with your legal and tax professionals for additional guidance tailored to your specific situation.

Asset allocation/diversification cannot guarantee a profit nor protect against loss in a declining market. Mutual funds are sold by prospectus only. Please consider the investment objectives, risk, charges and expenses carefully before investing. The prospectuses, which contain this and other information, can be obtained from your financial advisor. Read the prospectus carefully before investing. All investments involve risk including the potential of losing your principal.