On December 22, 2017, The Tax Cuts and Jobs Act was signed into law. The information in this article predates the tax reform legislation and may not apply to tax returns starting in the 2018 tax year. You may wish to speak to your tax advisor about the latest tax law. This publication is provided for your convenience and does not constitute legal advice. This publication is protected by copyright.
There are almost an infinite variety of mutual funds available: specializing in bonds, stocks, tax free instruments, foreign and domestic investments, growth stocks, income investments, specific industries and market segments, etc. Regardless of a specific fund’s investment strategy, most will generally pay some amount of dividends each year and those dividends will have a significant impact on your annual tax bite.
- Ordinary Dividends – Generally, a dividend is a distribution paid by a corporation to its shareholders. Companies that are profitable will often distribute some of the corporation’s profits in the form of dividends. A mutual fund will collect dividends from its investments and in turn pass a pro-rata share of these dividends on to the investors in the fund. In addition, if the fund has short-term capital gains from the sale of the funds’ investments held for less than one year, each investor’s pro-rata share of these short-term capital gains is added to ordinary dividends. This is the reason some funds, which invest solely in tax-free instruments, will still distribute taxable dividends even though the underlying portfolio is tax-free investments.
- Capital Gains Dividends – Represents the investor’s pro-rata share of long-term capital gains from the sale of the fund’s assets held over one year. These dividends receive the same special tax treatment as long-term capital gains and can be offset with any available capital losses from the sale of other capital assets. As with ordinary dividends, even though the fund may be invested in tax-free instruments, it may have long-term capital gains from the sale of some of its underlying portfolio.
- Foreign Taxes Withheld – By tax treaty with most nations, taxes are withheld at a specific percentage rate on investment earnings paid from the foreign country. Mutual funds will report both the amount of foreign dividends and the amount of taxes withheld. These numbers are used to compute the foreign tax credit.
As an investor, you have the option to have your dividends paid to you in cash or you may choose to reinvest your dividends and buy more shares of the fund that paid the dividends. But keep in mind, because you have the option to take the dividends in cash, the tax consequences of either form of dividend payment are the same: You are taxed on all dividends received. The exceptions to this tax rule are dividends held in tax-deferred investments, such as an IRA or 401(k).
When you reinvest the dividends, you are essentially purchasing additional shares of the fund with money on which you have already paid taxes. Therefore, you are adding to your basis in the fund. It is important to keep track of the reinvested dividends, so that when you sell your fund shares you can account for the additional purchases when figuring your gain or loss. For mutual funds purchased after 1996, many funds will track your tax basis in the fund for you. You should check with each fund to determine if they provide these basis-tracking services. For more specific information pertaining to your specific circumstances, please contact this office.