In general, most distributions you receive from a mutual fund must be declared as investment income on your yearly taxes. However, the type of distribution received, the duration of the investment holding, and the type of investment are all important factors in determining how much income tax you pay on each dollar of a distribution.

In some cases, distributions are subject to your ordinary income tax rate, which is the highest rate. In other cases, you may be eligible to pay the lower capital gains tax rate. Other distributions may be completely tax-free.

Ordinary Income Versus Capital Gains

The difference between ordinary income and capital gains income can make a huge difference to your tax bill. In short, only investment income you derive from investments held for a year or more is considered capital gains.

This concept is pretty straightforward when it comes to investing in individual stocks. The world of mutual funds, however, is a little more complicated.

Mutual funds are investment firms that invest the collective contributions of their thousands of shareholders in numerous securities called portfolios. When it comes to distributions, the difference between ordinary income and capital gains has nothing to do with how long you have owned shares in a mutual fund, but rather how long that fund has held an individual investment within its portfolio.

If you receive a distribution from a fund that results from the sale of a security the fund held for only six months, that distribution is taxed at your ordinary-income tax rate. If the fund held the security for several years, however, then those funds are subject to the capital gains tax instead. When a mutual fund distributes long-term capital gains, it reports the gains on Form 1099-DIV, Dividends and Distributions, and issues the form to you before the annual tax filing date.

Why Is This Important?

The difference between your ordinary income tax rate and your corresponding long-term capital gains tax rate can be quite large. This is why it is important to keep track of which income is subject to the lower rate. For 2019, those in the 10% and 12% income tax brackets are not required to pay any income tax on long-term capital gains. Individuals in the 22% to 35% tax brackets must pay a 15% tax on capital gains. Those in the highest income tax bracket of 37% are subject to a 20% capital gains tax.

Figuring Your Gains and Losses

If you sell your shares in a mutual fund, any amount of the proceeds that is a return of your original investment is not taxable, since you already paid income taxes on those dollars when you earned them. Therefore, it is important to know how to calculate the amount of your distribution attributed to gains rather than investments.

To determine how much of your investment income is gain or loss, you must first know how much you paid for the shares that were liquidated. This is called the basis. Because mutual fund shares are often bought at various times, in various amounts, and at various prices, it is sometimes difficult to determine how much you paid for a given share.

Cost Basis and Average Basis

There are two ways the IRS allows taxpayers to determine the basis of their investment income: cost basis and average basis.

If you know the price you paid for the shares you sold, then you can use the specific share identification cost basis method. However, if you own many shares that have been purchased at different times, this method may be very time-consuming. Alternatively, you can use the first-in, first-out cost basis method, in which you use the price of the first share purchased as the basis for the first share sold and so forth.

If you cannot determine the price you paid for specific shares, you may choose to use the average basis method, where you can use the aggregate cost of all your shares as the cost basis for each share sold. However, all your mutual fund shares must be identical to employ this method, meaning you cannot use the average basis method to figure your gains if some of your shares are part of a dividend reinvestment plan (DRIP) and some are not.

Like income from the sale of any other investment, if you have owned the mutual fund shares for a year or more, any profit or loss generated by the sale of those shares is taxed as long-term capital gains. Otherwise, it is considered ordinary income.