Related Tax FAQs
Mutual Fund Shares Taxation
How is a mutual fund taxed?
A mutual fund generally does not pay taxes if it complies with certain provisions under the Internal Revenue Code, including satisfying income, diversification, and distribution requirements.
How is a mutual fund shareholder taxed?
A shareholder that owns a mutual fund in a taxable account may be subject to tax on earnings generated in two ways. First, if a shareholder receives distributions from a fund, a portion of or all the distributions received may be subject to income tax. Second, shareholders that sell their shares of a fund and realize gains on the disposition of fund shares may also be subject to income taxation.
Please see below for more details on how mutual fund distributions and proceeds from the sale of mutual fund shares are taxed.
Tips to Reduce Your Tax Bill
What is your purpose for saving?
If you are saving for a specific event, such as retirement or your child's education, be sure to maximize your tax-deferred options before investing in a taxable account. (See our Retirement Center for details.)
How can I reduce my tax bill?
Holding a mutual fund in a taxable account will have income tax implications. However, there are various techniques that may be useful in attempting to reduce your tax bill due to mutual fund investments.
Time your purchases properly
A mutual fund generally distributes all the income it earns in the year which it is earned. Prior to such distribution, a fund's undistributed income and undistributed net realized gains are part of its net asset value (""NAV""). Once the undistributed amounts are paid by a fund in the form of a dividend, a fund's NAV is decreased by that amount. If you purchase fund shares just prior to a fund paying a dividend, you may be ""buying a dividend."" This means that a fund will distribute to you a dividend that generally is taxable; however, since you were not a shareholder at the time the fund earned the income, such distribution is essentially a taxable return of your investment.
Be mindful of holding periods
Prior to disposing a fund at a gain, consider whether you have met the long-term holding period. The difference between the long-term and short-term tax rates could be as much as 20%. If your holding period is one year or less, you may want to factor in the additional tax implications of a short-term holding period. A buy and hold strategy typically produces the most tax-efficient result.
Have you considered municipal bond funds?
Dividends from a municipal bond fund generally are exempt from federal income taxes; therefore, depending on your income tax bracket, they may produce a higher after-tax yield than some taxable income funds. However, you should understand that the income derived from a municipal bond may be subject to the alternative minimum tax and state and local taxes may apply. Also, in rare cases, a municipal bond may be reclassified by the IRS as taxable, therefore creating taxable rather than tax-free income.
Sale of Mutual Fund Shares
What about dividends being reinvested?
By electing to reinvest your dividends, you are instructing the fund to purchase additional shares with the dividend instead of receiving the dividend in cash. The holding period for the additional shares purchased by using the dividend generally begins on the date after the reinvestment.
What types of transactions would generate a realized capital gain or loss?
The sale or redemption of fund shares would generally trigger a taxable event. Sales also include participation in systematic withdrawal plans. The exchange of one fund for another fund also would trigger a taxable event because an exchange is similar to selling one fund and using the proceeds to purchase shares of a new fund.
How are gains or losses on the sale of fund shares computed?
In order to determine the gain or loss on the disposition of fund shares, you must compare the amount you realized (generally the net proceeds) to the adjusted cost basis (generally the amount you paid adjusted accordingly). If the amount you realized is more than the adjusted cost basis, you have a gain. If the amount you realized is less than the adjusted cost basis, you have a loss.
What is the difference between long-term and short-term capital gains?
Short and long-term relate to the length of time you hold a fund. Generally, if you hold a fund for more than one year from the purchase date to the sale date, the gain or loss on this transaction will be considered long-term. Fund shares held for one year or less are considered short-term. Long-term gains are typically taxed at a lower rate than short term gains. Currently the maximum long term rate is 20%.
How is the holding period determined?
Generally, the holding period of a fund share begins the day after you purchase a fund and ends on the date the fund shares are sold. It is possible that shares of the same fund have been purchased at different times; therefore, a portion of your holdings of a fund may produce long-term gains (losses) and a portion may produce short-term gains (losses). To determine how long you held your shares, begin counting on the day after the trade date on which you bought the shares (do not include the trade date itself). The trade date on which you sold the shares is counted as part of your holding period.
If I exchange one fund for another fund within the same fund family, is that a taxable transaction?
Yes. Each fund is considered a separate company for tax purposes; therefore, if you exchange out of one fund and into another, the transaction will be treated as if you sold shares in one company and purchased another, causing the transaction to be taxable. It should be noted that if you originally bought a fund with a sales charge, then exchange out of that fund and into another fund in the same fund family within 90 days, and the sales charge is waived for exchanges, you may not be able to take into account the sales charge paid in determining your gain or loss due to the exchange. The sales charge paid is generally added to the cost of the new fund. (See IRS Publication 550 for additional details.)
Mutual Fund Distributions
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.
Cost Basis of Investment
How is the adjusted cost basis computed?
In order to compute the adjusted cost basis, you must first determine the original cost. The original cost is the purchase price of the shares plus any commission or load charges paid. The original cost basis may then need to be adjusted by certain items, the most common of which is a return of capital paid by the fund. If a fund pays a return of capital, also known as a nondividend distribution, the original cost basis should be reduced (but not below zero) by the amount of return of capital received. It should be noted that shares acquired by gift, inheritance, or other particular acquisitions have other special rules to determine the adjusted cost basis.
Which method of disposing shares is better?
The specific identification method of selecting shares gives you the most flexibility with regards to tax planning. For example, you may want to generate some losses to offset gains produced from the sale of another security. If you hold a fund that was purchased numerous times at different prices, you have the ability to choose the lots that would generate a loss. One potential disadvantage of using the specific identification method is the time and effort that is needed in order to properly track each lot separately. The average cost method may be the easiest method to use because most fund families will compute your gain or loss on the sale of shares as a service to fund shareholders.
Are all dispositions of fund shares that are held for one year or less considered short-term capital losses?
No. If you received a long-term capital gain dividend and sold your shares at a loss and your holding period was six months or less, the short-term capital loss will be considered a long-term capital loss to the extent of long-term capital gain dividends received.
Do I need to compute my cost basis manually?
Beginning with shares purchased after January 1, 2012 (covered shares), Lord Abbett is required to compute and report the basis of shares sold to you and the IRS. This cost-basis information will appear on your Form 1099-B. Specifically, if Box 5 is blank, the transaction relates to covered shares, the basis will be reported to the IRS, and you are required to use this information when preparing your income tax return. As a service to our shareholders, we will provide you with the average cost basis on noncovered shares (to the extent available). You are not required to use the average cost-basis information provided for noncovered shares, and it will not be reported to the IRS as noted above.
For additional information on Mandatory Cost Basis Reporting, please visit our cost basis resource center.
What is a "wash sale"?
If you sold a fund at a loss and repurchased the same fund within the period 30 days before and 30 days after the trade date (the 61-day window); such a loss may be disallowed to the extent of the repurchased positions. It also should be noted that dividends reinvested are considered purchases and, therefore, may potentially cause a wash sale if reinvested within the 61-day window of the sale at a loss.
What information do I need in order to compute my original basis and holding period?
In order to compute your adjusted cost basis, you must first determine your original cost. The information needed in order to determine the original cost basis and holding period of shares that were purchased and not inherited or gifted is:
• Trade date of each purchase, including dividend reinvestments;
• The number of shares purchased;
• Cost of the shares purchased; and
• Any sales charge or commission paid for each purchase.
How do I determine which shares are sold?
If you held a fund for numerous years, participated in an automatic investment plan or elected to reinvest dividends, you will hold many small lots of shares purchased at different points in time at different prices. These lots will have different adjusted cost basis and holding periods. In order to determine which shares are sold, you may use specific identification, first in first out (FIFO), or an average cost method. If either of the first two methods are used, you need to track each lot's adjusted basis and holding period separately in order to determine the gain or loss on disposition. If an average cost method is used, you would still need adjusted cost and holding period information, but the gain or loss is determined based upon the average cost of the shares. Average cost methods may be used only for mutual fund investments.
(See IRS Publication 550 for detailed instructions on how to compute gains or losses.)
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The information presented in this section is intended for general information and is not intended to be relied upon and should not be relied upon, as financial, legal or tax advice for any particular investor. We strongly recommend that you contact your financial, legal or tax advisor regarding your particular tax situation.
The information presented in this section is not written or intended to be used, and cannot be used, for the purpose of avoiding any tax liabilities or penalties.