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?