As part of ThinkAdvisor’s Special Report, 23 Days of Tax Planning Advice: 2016, throughout the month of March, we are partnering with our ALM sister service, Tax Facts Online, to take a deeper dive into certain tax planning issues in a convenient Q&A format.
1. What are ordinary income dividends from a mutual fund? How are ordinary income dividends received from a mutual fund taxed?
Ordinary income dividends are derived from the mutual fund’s net investment income (i.e., interest and dividends on its holdings) and short-term capital gains. A shareholder generally includes ordinary income dividends in income for the year in which they are received by reporting them as “dividend income” on the shareholder’s income tax return.
However, under JGTRRA 2003, qualified dividend income is treated in some respects like net capital gain and is, therefore, eligible for what are now the 20/15/0 percent tax rates instead of the higher ordinary income tax rates. (ATRA 2012 made the special treatment of “qualified dividends” permanent—or as permanent as anything in the IRC.) As a result of JGTRRA 2003, mutual funds are required to report on Form 1099-DIV the nature of the ordinary dividend being distributed to shareholders—that is, whether the ordinary dividend is a “qualified dividend” subject to the 20/15/0 percent rates (Box 1b), or a nonqualifying dividend subject to ordinary income tax rates (Box 1a). Unless otherwise designated by the mutual fund, all distributions to shareholders are to be treated as ordinary income dividends.
Ordinary income dividends paid by mutual funds are eligible for the 20/15/0 percent rate if the income being passed from the fund to shareholders is qualified dividend income in the hands of the fund and not short-term capital gains or interest from bonds (both of which continue to be taxed at ordinary income tax rates).
2. What are exempt interest dividends? How are exempt interest dividends received from a mutual fund taxed?
Some mutual funds invest in securities that pay interest exempt from federal income tax. This interest may be passed through to the fund’s shareholders, retaining its tax-exempt status, provided at least 50 percent of the fund’s assets consist of such tax-exempt securities. Thus, a shareholder does not include exempt-interest dividends in income. The mutual fund will send written notice to its shareholders advising them of the amount of any exempt-interest dividends. Any person required to file a tax return must report the amount of tax-exempt interest received or accrued during the taxable year on that return. Under JGTRRA 2003, exempt-interest dividends do not count as qualified dividend income for purposes of the 20/15/0 percent tax rates.
3. What are capital gain dividends? How are capital gain dividends received from a mutual fund taxed?
Capital gain dividends result from sales by the mutual fund of stocks and securities that result in long-term capital gains. The mutual fund will notify shareholders in writing of the amount of any capital gain dividend. The shareholder reports a capital gain dividend on the federal income tax return for the year in which it is received as a long-term capital gain regardless of how long the shareholder has owned shares in the mutual fund. As such, a capital gain dividend may be partially or totally offset by the shareholder’s capital losses (if any); if not totally offset by capital losses, the excess (i.e., net capital gain) will be taxed at the applicable capital gains rate.
Generally, a shareholder may elect to treat all or a portion of net capital gain (i.e., the excess of long-term capital gain over short-term capital loss) as investment income. If the election is made, the amount of any gain so included is taxed as investment income. This election may be advantageous if the shareholder’s investment interest expense would otherwise exceed his investment income for the year. If the shareholder makes the election, the shareholder must also reduce net capital gain by the amount treated as investment income.
Detailed instructions for reporting mutual fund distributions on Form 1040 or Form 1040A are set forth in IRS Publication 550, Investment Income and Expenses (2013) (formerly, Publication 564, Mutual Fund Distributions (2011)).
4. How is the shareholder taxed if the mutual fund pays a dividend in its portfolio stocks or securities rather than in cash?
The taxability of a dividend distribution is the same whether the distribution is in cash or portfolio stock or securities; thus, the distribution will be treated as an ordinary income dividend, exempt-interest dividend, or capital gains dividend, as the case may be. The amount (if any) that the shareholder reports on an income tax return is the fair market value of the stocks or securities received as of the date of distribution.
5. How are dividends that are automatically reinvested taxed?
Some mutual funds automatically reinvest shareholder dividends under a plan that credits the shareholder with additional shares, but gives the shareholder the right to withdraw the dividends at any time. Even though the dividend is not distributed directly to the shareholder, it is credited to the shareholder’s account. Such dividends are considered “constructively” received by the shareholder and are included in the shareholder’s income for the year in which they are credited to the shareholder’s account. The basis of the new shares is the net asset value used to determine the dividend (i.e., the amount of the dividend used to purchase the new shares).
– See ThinkAdvisor’s complete tax planning lineup on our 23 Days of Tax Planning Advice: 2016 home page.