What is the source of a mutual fund's income?

Mutual funds generate gains by selling investments that have increased in value. They also generate income by receiving dividends and accruing interest, net of expenses, on securities held within the portfolio. All income and capital gains earned by a mutual fund are required to be distributed to shareholders of the fund in the form of a dividend in order for the mutual fund to avoid paying corporate level taxes. The shareholders who receive the dividend pay taxes on the amount of dividends they receive.

Are all ordinary income distributions qualified dividends and, therefore, subject to the reduced maximum tax rate of 20%?

No. In general, the maximum amount of qualified dividends a fund can pass through to its shareholders is limited to the amount of qualified dividend income the fund received. If a fund earned income from interest, short-term capital gains, currency gains, certain foreign companies, or other nonqualifying sources, then a portion of a fund's ordinary income distribution may not be a qualified dividend. Nonqualified dividends are subject to ordinary income tax rates.

Are qualified dividends subject to any other taxes?

Taxpayers with modified adjusted gross income in excess of $200,000 ($250,000 if married) must pay an additional 3.8% in Medicare tax on the lesser of all net investment income or the amount of income in excess of the threshold. Net investment income includes taxable income and capital gains earned from an individual’s mutual fund investments, which includes qualified dividends.

Are my reinvested dividends taxable?

Yes. A dividend received in cash or reinvested will be taxable to the shareholder. If a dividend is reinvested, it is similar to a shareholder receiving the dividend in cash and automatically reinvesting it into a fund. The reinvestment of a dividend is deemed to be a purchase of additional shares in a fund.

Are long-term capital gain distributions considered long term if I held the fund for less than one year?

Yes. Long-term capital gain distributions are always considered long term, regardless of how long you held the fund. There is no holding period requirement in order to take advantage of the lower tax rate afforded to long-term capital gain distributions.

Why do mutual funds pay dividends?

Each mutual fund is treated by the Internal Revenue Code as a separate corporation for tax purposes. However, unlike a regular corporation that is subject to "double taxation" (taxed once on earnings generated at the corporate level and again on dividends paid relating to the same earnings at the shareholder level), mutual funds may "pass through" income earned to their shareholders without paying corporate level taxes. In order to avoid corporate level taxes, a mutual fund must meet certain IRC requirements. One of these requirements is that the mutual fund must distribute substantially all the income it earns to its shareholders in the year which it is earned.

What kinds of distributions are paid by a mutual fund?

In order to preserve some of the tax characteristics of the income as generated by the fund, a fund may pay different kinds of distributions. The most common are listed below:

Long-term capital gain distributions – Net gains on securities held for more than one year are considered long-term. Long-term capital gains are currently taxed at the maximum tax rate of 20%.

Ordinary income distributions – Net investment income (dividends and interest less expenses), short-term capital gains (securities held for one year or less), and various other types of gains are considered ordinary income. Ordinary income distributions generally are taxable to the shareholder at the ordinary income tax rates.

Tax-exempt distributions – If a fund invests primarily in direct municipal obligations, it may deem all or a portion of its net investment income distributions exempt from federal income taxes.

Return of capital – A distribution made by a fund in excess of its earnings and profits for tax purposes will be considered a tax return of capital. A return of capital is generally not taxable to the shareholder and reduces the shareholder's adjusted basis (not below zero) in a fund.

What is a "qualified dividend"?

A qualified dividend is a dividend paid by certain U.S. corporations or qualified foreign corporations. A mutual fund can pass through those qualified dividends to its shareholders, provided that the mutual fund has satisfied certain holding period requirements. If the conditions are satisfied, the maximum tax rate for qualified dividends is 20%. The portion of the ordinary income dividends paid to you that is eligible for the reduced tax rate will be provided on Form 1099-DIV. To benefit from the lower tax rate on qualified dividends, you generally must have held your shares in the mutual fund for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date.

Are all ordinary income dividends taxed at the same rate?

Ordinary income dividends are taxed at the shareholder's ordinary income rate, which is currently as high as 37%. If a fund receives qualified dividends (i.e., a dividend paid by certain U.S. corporations or qualified foreign corporations) and passes through those dividends to its shareholders, the maximum income tax rate is 20% if certain conditions are met.

Related Tax FAQs | Lord Abbett