How Tax on Mutual Funds Works & 6 Ways to Cut the Bill

You may have to pay certain taxes while you own your mutual fund shares and again after you sell. Here's how to minimize the tax bill.

Tina Orem
Assistant Assigning Editor | Taxes, small business, Social Security and estate planning, home services

Tina Orem is an editor at NerdWallet. Prior to becoming an editor, she covered small business and taxes at NerdWallet. She has been a financial writer and editor for over 15 years, and she has a degree in finance, as well as a master's degree in journalism and a Master of Business Administration. Previously, she was a financial analyst and director of finance for several public and private companies. Tina's work has appeared in a variety of local and national media outlets.

Arielle O'Shea
Lead Assigning Editor | Retirement planning, investment management, investment accounts

Arielle O’Shea leads the investing and taxes team at NerdWallet. She has covered personal finance and investing for over 15 years, and was a senior writer and spokesperson at NerdWallet before becoming an assigning editor. Previously, she was a researcher and reporter for leading personal finance journalist and author Jean Chatzky, a role that included developing financial education programs, interviewing subject matter experts and helping to produce television and radio segments. Arielle has appeared on the "Today" show, NBC News and ABC's "World News Tonight," and has been quoted in national publications including The New York Times, MarketWatch and Bloomberg News. She is based in Charlottesville, Virginia.

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• Dividend payments, interest payments or securities sales within a fund can generate tax liability for its shareholders.
• You may also incur tax if you sell shares of a mutual fund for a profit.
• Waiting to sell, using a tax-advantaged account, working with a professional, harvesting losses and getting familiar with your funds' holdings can minimize tax liability.

Mutual fund taxes typically include taxes on dividends and earnings while the investor owns the mutual fund shares, as well as capital gains taxes when the investor sells the mutual fund shares. The tax rate (and in turn the tax on mutual funds) depends on the type of distribution and other factors.

That means you may owe tax on mutual funds you’ve invested in — even if you haven’t sold any of the shares or received any cash from your investments.

Here’s an overview of how and when you pay tax on mutual funds, plus six things you can do to pay less tax.

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When do you owe tax on mutual funds that you own?

Two things can happen while you own your mutual fund that might generate a tax bill. Your mutual fund might pay your share of the dividends or interest that the underlying securities paid during the year. Or, the fund manager might sell some of the securities for-profit and then give you your share of that profit.

A mutual fund combines money from many investors and invests it in assets such as stocks and bonds. Professionals manage the mutual fund and decide when to buy and sell stocks, bonds or other assets in the portfolio. The investors own shares of the mutual fund and pay an annual fee to cover the cost of operating the fund. The value of those shares can rise or fall depending on how the underlying securities in the mutual fund perform.

IRS Publication 550 has the details on the tax rules for investment income and expenses [0]

1. Tax on mutual funds if you get dividends or interest

Dividends are usually taxable income. When you invest in a mutual fund, you usually get to choose whether you want your share of the dividends distributed to you or automatically reinvested into the mutual fund. If you opt to reinvest your dividends, the IRS generally still considers that money taxable.

Mutual funds that invest in bonds might receive interest payments from those bond investments. Your portion of that interest may also be taxable income, even if you reinvest it. The interest on some bonds, including municipal bonds and U.S. Treasurys , may be tax-free.

If your mutual fund distributes dividends or interest during the year, you’ll probably get an IRS Form 1099-DIV or 1099-INT the following January showing how much you received from the fund. You’ll use the form to report the income on your tax return. Don’t ignore these forms. The sender gives a copy to the IRS, so the IRS is probably going to notice if you don’t report the income.

2. Tax on mutual funds if the fund managers generate capital gains

If the mutual fund’s managers sell securities in the fund for a profit, the IRS will probably consider your share of that profit a capital gain. Generally, mutual funds distribute these net capital gains to investors once a year.

You’ll probably get an IRS Form 1099-DIV in January showing your portion of the fund’s capital gains during the previous year. You’ll need this form to report your capital gain on your tax return.

Again, don’t ignore your 1099-DIV; the IRS is going to get a copy, and sooner or later it will probably realize if you don’t report the income.

Your tax on capital gains earned while you still own shares of the mutual fund depends in part on how long the fund held the investments.

Tax on mutual funds when you sell

Because a mutual fund invests your money in a variety of assets such as stocks and bonds, the value of your mutual fund’s shares — and your investment — can rise or fall depending on how those underlying securities perform. That can lead to taxes when you sell.

You might sell your mutual fund shares for more than you paid or for more than the cost basis. (That’s usually the goal.) That profit is a capital gain. Capital gains are taxable income.

If you’re like most people and bought your mutual fund shares a little at a time, you probably own a bunch of mutual fund shares that you purchased at various prices.

There are a few different methods for determining exactly which shares you’re selling and how much profit you’re making. In a nutshell, you can specify the exact shares you’re selling, sell the oldest shares first or use the average cost of all the shares you own. The choice is important because it can influence how you calculate your profit and how much tax you might owe.

How long you own your mutual fund shares also matters. If you owned them for more than a year before selling, your capital gains tax rate may be lower.

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6 quick tips to minimize the tax on mutual funds

Wait as long as you can to sell. Selling in less than a year can trigger higher capital gains taxes if you make a profit.

Buy mutual fund shares through your traditional IRA or Roth IRA. If you put money in a traditional IRA , your investments grow tax-deferred; you’re not taxed until you withdraw money. If you put money in a Roth IRA , there are no taxes on investment growth, interest or dividends if you withdraw them after age 59 ½ and have the IRA for at least five years.

Buy mutual fund shares through your 401(k) account. If you put money in a traditional 401(k) account, taxes are deferred until you withdraw the money.

Know what kinds of investments the fund makes. If you don’t want a lot of taxable dividends headed your way every year, for example, then you may not want to invest in a mutual fund that owns a lot of dividend-paying stocks. If you don’t want a lot of taxable capital gains distributions hitting you while you own the shares, then you might favor index funds, which tend to buy and sell their underlying investments infrequently.

Use tax-loss harvesting . If your investments are in a taxable account, you might be able to offset some taxes by selling other underperforming mutual funds or securities at a loss. Those losses can offset some or all of your investment gains.

See a tax professional. There are other ways to minimize your mutual fund taxes, too, so find a C P A or other tax professional and discuss your options.

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Tina Orem is an editor at NerdWallet. Before becoming an editor, she was NerdWallet's authority on taxes and small business. Her work has appeared in a variety of local and national outlets. See full bio.

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