Dividend Distribution
In addition to distributing income generated by the sale of assets, mutual funds also make dividend distributions when underlying assets pay earnings or interest. Mutual funds are pass-through investments, which means any income they receive must be distributed to shareholders. This most often occurs when a fund holds dividend-bearing stocks or bonds, which typically pay a regular amount of interest annually, called a coupon.


When a company declares a dividend, it also announces the ex-dividend date and date of record. The date of record is the date on which the company reviews its list of shareholders who will receive the dividend payment. Because there is a time delay when trading stocks, any sale of shares that occurs fewer than three days before the date of record is not registered, and the list of shareholders still includes the name of the selling investor. The date three days before the date of the record is the ex-dividend date.

How Are Dividend Distributions Taxed?

In general, dividend income is taxed as ordinary income. If your mutual fund buys and sells dividend stocks often, more than likely any dividends you receive are taxed as ordinary income. For example, assume you receive $1,000 in dividend payments from your actively managed fund. If you are in the 24% income tax bracket, you pay $240 at tax time.

However, there are two very important exceptions: qualified dividends and tax-free interest.

Qualified Dividends

Dividend distributions received from your mutual fund may be subject to the capital gains tax if they are considered qualified dividends by the IRS. To be qualified, the dividend must be paid by a stock issued by a U.S. or qualified foreign corporation. Also, your mutual fund must have held the stock for more than 60 days within the 121-day period beginning 60 days before the ex-dividend date.

The ex-dividend date is the date after which the owners of newly purchased stock are ineligible for the dividend payment. If the ex-dividend date is April 12, for example, any investors who purchase stock on or after this date do not receive the impending dividend.

This may sound confusing, but essentially it means the fund must own the stock for either 60 days before the ex-dividend date or a combination of days before and afterward, adding up to at least 60 days. This complicated requirement is meant to discourage investors from purchasing funds with dividend-bearing stocks right before payments and then selling them off again, just to get the dividend. If your fund distributes qualified dividends, these dividends are reported to you on Form 1099-DIV.

Tax-Free Interest

The other way to minimize your income tax bill is to invest in so-called tax-free mutual funds. These funds invest in government and municipal bonds, also called "munis," that pay tax-free interest. Money market mutual funds, for example, invest primarily in short-term government bonds and are widely considered stable and safe investments.

However, while municipal bonds pay interest that is exempt from federal income tax, they may not be exempt from your state income tax or local income taxes. In some cases, interest paid on bonds issued by governments in your state of residence may be triple-tax-free, meaning the bonds are exempt from all income tax. However, verify with your fund which bonds within its portfolio are tax-free and to what degree in order to avoid being blindsided by unexpected taxation.

The Bottom Line

Calculating the taxes you owe on mutual fund income and distributions can be extremely complex, even for the most seasoned investor. Unless you own just a handful of shares and keep careful records, you may benefit from consulting a tax professional to ensure you are properly reporting all your investment income.