How to Report Mutual Fund Income to the IRS
Millions of former bank depositors are now learning what about 36 million Americans already know: Investing in mutual funds can make filing an annual tax return dramatically more complicated.
“It’s a quagmire,” complains one professional tax preparer. “Mutual fund tax laws are absolutely impossible to figure out.”
Mutual fund experts say that’s an overstatement. But they do acknowledge that computing your tax when investing in a mutual fund is no picnic.
The complexity stems from a number of factors, including some that are meant to help investors. Investors are allowed to choose one of several methods to compute gains and losses, for example. That allows you to pick the method that is easiest or that lowers your tax bill. But those who want to minimize their tax may need to do several computations before they decide which method to use.
Where to report mutual fund earnings on a tax return can even be traumatic. You may assume that income from money market funds should be reported as “interest,” for example. But because it came through the mutual fund, it’s actually called dividends. If you report the income on the wrong line, you could be forced to explain the mistake to the IRS.
In some cases, how you report your fund earnings even can affect how much you pay in tax.
How can you make sense of it all? Here’s the first in a three-part guide that attempts to answer the questions you might have when investing in mutual funds. This part deals with how to report mutual fund income. Part two helps investors figure taxable gains and losses. And part three will talk about so-called tax-free funds, which sometimes distribute taxable income.
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Q: How many types of income might I earn on a mutual fund?
A: Six. You can earn long-term capital gains, short-term capital gains, taxable dividends, non-taxable dividends, federally taxed dividends and dividends that are only subject to state taxes.
Q: What about the interest I earn on a money market or bond fund?
A: Many people believe that they’re earning interest when they invest in money market or bond funds, but they’re actually earning dividends. That’s because you invested in a mutual fund. The mutual fund invested in the interest-bearing products, such as bank certificates of deposit and Treasuries. The mutual fund earns interest on the money it invests. When it distributes its earnings, it pays you dividends.
Q: What is the difference between short-term and long-term capital gains?
A: High-income taxpayers may pay less tax on long-term gains than short-term gains.
Q: How do I distinguish a long-term gain from a short-term gain?
A: All the capital gains that are passed through to you from the fund are considered long-term gains. In other words, when the fund reports a profit from selling some of its holdings, and passes part of that profit on to you, you declare it on your tax return as a long-term gain.
Additionally, if you hold shares in a fund for more than 365 days, the gain you earn when you sell those shares is a long-term capital gain. If you owned your fund shares for less than a year, it’s a short-term gain.
Q: What are taxable dividends?
A: Almost any dividend declared and paid by a mutual fund--with the exception of dividends paid from interest earnings on tax-free government securities--are taxable dividends. The one exception is when a fund returns some of your capital.
Q: What’s a return of capital?
A: It’s a distribution that is not paid out of the earnings and profit of the mutual fund. In other words, a return of your investment.
Q: How do I report that?
A: You don’t until you sell your mutual fund shares. You just keep track of it, because it will reduce your tax “basis.” For example, you bought one share in fund XYZ for $100, but the fund later returned $20 of your investment. Your tax basis--essentially the cost of your investment--drops to $80. So, when you sell for $90, you’ll declare a $10 capital gain, rather than a $10 capital loss.
Q: How do I know when part of my dividend is a return of capital?
A: The fund company would report it as such on a 1099-DIV. If it’s not spelled out as a return of capital on this form, it’s an ordinary dividend.
Q: Where do I report a capital gain on my tax return?
A: If you’re single and earn less than $51,900 or married, filing jointly and earn less then $86,500, you can report both long-term and short-term capital gains on Line 14 of the individual tax return, form 1040.
If you earn more than that, and have long-term gains, you should fill out a separate form, called Schedule D. That’s because you pay a maximum rate of 28% on long-term capital gains versus about 31% on ordinary income. The only place to compute that lower rate is on the Schedule D. If you don’t fill out this form, you’re probably paying too much tax.
Q: What about dividends from tax-free funds?
A: You report them on a Schedule B, the form for interest and dividend income. That form asks you to list all dividend income, but allows you to subtract back distributions that are not taxable. The final tally will also be noted on Line 9 of your 1040.
FOR THE RECORD: A recent article on tax records incorrectly stated that Medicare premiums are deductible medical expenses. Only premiums paid for Medicare Part B are deductible.
