The Basics of Determining Taxes on Mutual Funds

Learn about capital gains, cost basis, qualified dividends, and more

Reviewed by Julius Mansa
Fact checked by Vikki Velasquez

Many investors have questions about the best way to calculate their taxes on mutual funds. The way your mutual fund is treated for tax purposes has a lot to do with the type of investments within the fund’s portfolio.

In general, most distributions you receive from a mutual fund must be declared as investment income on your yearly taxes. However, the type of distribution received, the duration of the investment holding, and the type of investment are all important factors in determining how much income tax you pay on each dollar of a distribution.

In some cases, distributions are subject to your ordinary income tax rate, which is the highest rate. In other cases, you may be eligible to pay the lower capital gains tax rate. Other distributions may be completely tax-free.

Key Takeaways

• Mutual funds that create a lot of short-term capital gains—and are taxed at ordinary income (not capital gains) rates—can cost you.
• When it comes to distributions, the difference between ordinary income and capital gains is based on how long that fund has held an individual investment within its portfolio.
• If you receive a distribution from a fund that results from the sale of a security the fund held for only six months, that distribution is taxed at your ordinary income tax rate.
• If the fund held the security for several years, however, then those funds are subject to the capital gains tax instead.

Ordinary Income vs. Capital Gains

The difference between ordinary income and capital gains income can make a huge difference to your tax bill. In short, only investment income you derive from investments held for more than a year is considered capital gains.

This concept is pretty straightforward when it comes to investing in individual stocks. The world of mutual funds, however, is a little more complicated.

Mutual funds are investment companies that invest the collective contributions of their thousands of shareholders in numerous securities called portfolios. When it comes to distributions, the difference between ordinary income and capital gains has nothing to do with how long you have owned shares in a mutual fund but rather how long that fund has held an investment within its portfolio.

If you receive a distribution from a fund that results from the sale of a security the fund held for less than a year, that distribution is taxed at your ordinary income tax rate. If the fund held the security for 12 months or more, however, then those funds are subject to the capital gains tax instead.

When a mutual fund distributes long-term capital gains, it reports the gains on Form 1099-DIV, Dividends, and Distributions, and issues the form to you before the annual tax filing date.

Why Is This Important?

The difference between your ordinary income tax rate and your corresponding long-term capital gains tax rate can be quite large. This is why it is important to keep track of which income is subject to the lower rate. Ordinary income is taxed at either 10%, 12%, 22%, 24%, 32%, 35%, or 37% depending on filing status and income.

The capital gains tax rates are 0%, 15%, and 20%, and will depend on your filing status and income. Below are the tax rates and income brackets for capital gains for 2024 and 2025. Note that if you earn above the 15% maximum amount, your capital gains tax will be 20%.

Figuring Your Gains and Losses

If you sell your shares in a mutual fund, any amount of the proceeds that is a return on your original investment is not taxable since you already paid income taxes on those dollars when you earned them. Therefore, it is important to know how to calculate the amount of your distribution attributed to gains rather than investments.

To determine how much of your investment income is gain or loss, you must first know how much you paid for the shares that were liquidated. This is called the basis. Because mutual fund shares are often bought at various times, in various amounts, and at various prices, it is sometimes difficult to determine how much you paid for a given share.

Important

Mutual fund investors can face unexpected tax bills even when a fund’s value declines, as taxable distributions may still occur when the fund manager sells appreciated assets.

Cost Basis and Average Basis

There are two ways the Internal Revenue Service (IRS) allows taxpayers to determine the basis of their investment income: cost basis and average basis.

If you know the price you paid for the shares you sold, then you can use the specific share identification cost basis method. However, if you own many shares that have been purchased at different times, this method may be very time-consuming. Alternatively, you can use the first-in, first-out cost basis method, in which you use the price of the first share purchased as the basis for the first share sold and so forth.

If you cannot determine the price you paid for specific shares, you may choose to use the average basis method, where you can use the aggregate cost of all your shares as the cost basis for each share sold. However, all your mutual fund shares must be identical to employ this method, meaning you cannot use the average basis method to figure your gains if some of your shares are part of a dividend reinvestment plan (DRIP) and some are not.

Like income from the sale of any other investment, if you have owned the mutual fund shares for a year or more, any profit or loss generated by the sale of those shares is taxed as long-term capital gains. Otherwise, it is considered ordinary income.

Dividend Distributions

In addition to distributing income generated by the sale of assets, mutual funds also make dividend distributions when underlying assets pay earnings or interest. Mutual funds are pass-through investments, which means any income they receive must be distributed to shareholders.

This most often occurs when a fund holds dividend-bearing stocks or bonds, which typically pay a regular amount of interest annually, called a coupon.

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 before the date of record is not registered, and the list of shareholders still includes the name of the selling investor. The date before the date of the record is the ex-dividend date.

How Are Dividend Distributions Taxed?

In general, dividend income is taxed as ordinary income. 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 24% income tax bracket, you pay $240 at tax time.

However, there are two very important exceptions: qualified dividends and tax-free interest.

Qualified Dividends

Dividend distributions received from your mutual fund may be subject to the capital gains tax if they are considered qualified dividends by the IRS. To be qualified, the dividend must be paid by a stock issued by a U.S. or qualified foreign corporation. Also, your mutual fund must have held the stock for more than 60 days within the 121-day period beginning 60 days before the ex-dividend date.

The ex-dividend date is the date after which the owners of newly purchased stock are ineligible for the dividend payment. If the ex-dividend date is April 12, for example, any investors who purchase stock on or after this date do not receive the impending dividend.

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 afterward, adding up to at least 60 days. This complicated requirement is meant to discourage investors from purchasing funds with dividend-bearing stocks right before payments and then selling them off again, just to get the dividend. If your fund distributes qualified dividends, these dividends are reported to you on Form 1099-DIV.

Tax-Free Interest

The other way to minimize your income tax bill is to invest in so-called tax-free mutual funds. These funds invest in government and municipal bonds, also called “munis,” that pay tax-free interest. Money market mutual funds, for example, invest primarily in short-term government bonds and are widely considered stable and safe investments.

However, while municipal bonds pay interest that is exempt from federal income tax, they may not be exempt from your state income tax or local income taxes. In some cases, interest paid on bonds issued by governments in your state of residence may be triple-tax-free, meaning the bonds are exempt from all income tax. To avoid being caught off guard by unexpected taxation, verify with your fund which bonds within its portfolio are tax-free and to what degree.

How Are Distributions From Mutual Funds Taxed?

Most mutual fund distributions are considered taxable investment income. The tax rate depends on factors like the holding duration of the investment within the fund and the nature of the distribution, which could be ordinary income, capital gains, or sometimes tax-free.

What’s the Difference Between Ordinary Income and Capital Gains?

Ordinary income typically includes short-term capital gains (from assets held under a year) and is taxed at standard income tax rates. Long-term capital gains, from assets held over a year, are generally taxed at lower rates (0%, 15%, or 20%), which depend on your income bracket.

How Can I Reduce Taxes on Mutual Fund Distributions?

Investing in tax-advantaged accounts, like IRAs, choosing funds that focus on tax-free municipal bonds, or opting for tax-efficient funds can help lower tax burdens. Additionally, qualified dividends and long-term capital gains rates may offer tax savings if distributions are eligible.

The Bottom Line

Calculating the taxes you owe on mutual fund income and distributions can be extremely complex, even for the most seasoned investor. The IRS’s Publication 550, Investment Income and Expenses (Including Capital Gains and Losses) can be some help in informing you about these issues. But unless you own just a handful of shares and keep careful records, you may benefit from consulting a tax professional to ensure you are properly reporting all your investment income.