10 Mar Mutual fund distributions and your tax return

 Q. Can you explain how mutual fund distributions work and what they mean for my tax return? I think I have a surprise this year that I’m not going to like.

A. Mutual funds offer an easy way for investors to invest small amounts into diversified portfolios in most asset classes. But you’re right. Figuring out how you’re taxed on a fund can be a little confusing.

First, why are mutual funds such a popular investment choice?

“A main advantage is the ability to access professional management without having to meet high minimum investment requirements,” said Gerard Papetti, a certified financial planner and certified public accountant with U.S. Financial Services in Fairfield. “Mutual funds are investment vehicles that pool funds collected from many investors and are managed by a fund manager or a management team to accomplish the funds objective as stated in its prospectus.”

He said some mutual funds are managed to produce current income, some are managed to produce capital gains and some may be a combination of both.

Each shareholder of a mutual fund participates proportionally in the gain or loss of the fund based on the number of shares they own to the total shares outstanding, Papetti said. Mutual fund units, or shares, are issued and can typically be purchased or redeemed as needed at the fund’s current net asset value (NAV) per share.

Now, the taxes.

“By law, mutual funds must pay out income and realized capital gains — those gains that result from the actual sale of securities owned by the fund — to the funds’ shareholders,” Papetti said. “Depending on the type of assets the fund owns, the distributions may be taxable, or in the case of a municipal bond mutual fund, the income distributions may be tax-free.”

He said realized capital gains are always subject to tax and can be classified as short-term (if the security was held less one-year) or long-term ( if the security was held one year or longer).

Papetti said these distributions come from a fund’s assets, which will decrease the fund’s net asset value (NAV) – and therefore its price – drops accordingly.

When a fund makes a distribution, shareholders can choose to be paid the distribution, or they can reinvest it to buy more shares of the fund, Papetti said.

“Whichever scenario mutual fund shareholders choose, they will be taxed on the distribution as well as benefit from the distribution paid to them in cash or reinvested in additional shares of the mutual fund,” he said.

Mutual fund distributions can take the form of a dividend, capital gain or non-taxable return of capital.

Papetti said mutual funds that invest in taxable bonds, stocks, real estate and other taxable investments will produce taxable distributions that will be subject to either ordinary income tax or preferential qualified dividends tax rate or long-term capital gains rate of 15 percent — or 20 percent if you have taxable income in excess of $406,750 for single filers or $457,600 for married filing joint taxpayers — for Federal tax purposes. He said the taxable distributions will also be subject to New Jersey income tax with no special rates for either qualified dividends or long-term capital gains.

“Therefore, the distributions you receive from the mutual funds you are invested in may be taxable and will be reported on Form 1099-DIV or 1099-B if you sold shares during the year,” Papetti said. “These distributions need to be reported on your tax return.”

Also, if the fund manages only tax-free municipal bonds, the income distribution will not be subject to ordinary income tax but could be subject to the Alternative Minimum Tax if the muni bonds are “private activity” bonds, Papetti said.

Capital gains tax can be mitigated by harvesting losses, said Alison Williams, a certified financial planner with Stonegate Wealth Management in Oakland.

That means you intentionally sell another holding that has fallen in value since the time of purchase, which allows you to offset the gains from other investments.

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This post first appeared in March 2015.