APPENDIX A:
Funds and Taxation

Unlike most corporations, a mutual fund generally distributes all of its earnings each year and is taxed only on amounts it retains. This specialized “pass-through” tax treatment of mutual fund income and capital gains was established under the Revenue Act of 1936 and endures today under Subchapter M of the Internal Revenue Code of 1986. This section includes:

a brief look at how funds qualify for specialized tax treatment;
a review of how investors employ funds for tax purposes;
a discussion of the types of taxable distributions that funds make; and
an explanation of tax consequences when investors sell or exchange fund shares.

Taxation of Fund Earnings

To qualify for specialized tax treatment under the Code, mutual funds must meet, among other conditions, various investment diversification standards and pass a test regarding the source of their income. For example, under the Code’s income test, 90 percent of the mutual fund’s gross income must be derived from certain sources. According to the Code’s asset tests, at least 50 percent of the fund’s assets must be invested in cash, cash items, government securities, securities of other funds, and investments in other securities which, with respect to any one issuer, do not represent more than 5 percent of the assets of the fund nor more than 10 percent of the voting securities of the issuer. Furthermore, not more than 25 percent of the fund’s assets may be invested in the securities of any one issuer (other than government securities or the securities of other funds) or of one or more qualified publicly traded partnerships. Fund investors are ultimately responsible for paying tax on a fund’s earnings, whether they receive the distributions in cash or reinvest them in additional fund shares.

Tax-Exempt Funds and Tax-Deferred Accounts

Investors often try to lessen the impact of taxes on their investments by investing in tax-exempt funds and tax-deferred retirement accounts. As of 2004, 8 percent of all mutual fund assets were invested in tax-exempt funds and 46 percent were invested in tax-deferred household accounts.

Tax-Exempt Funds

Tax-exempt bond funds pay dividends earned from municipal bond interest. This income is exempt from federal income tax and, in some cases, state and local taxes as well. Tax-exempt money market funds invest in short-term municipal securities or equivalent instruments and also pay exempt-interest dividends.

Share of Mutual Fund Assets by Tax Status, 2004

(percent)

*Households are defined to exclude mutual fund assets attributed to business corporations, financial institutions, nonprofit organizations, and other institutional investors.
Note: Components do not add to 100 percent because of rounding.
Download an Excel file of this data.

Even though income from these funds is generally tax-exempt, investors must report it on their income tax returns. Tax-exempt funds provide investors with this information in a year-end statement, and typically explain how to handle tax-exempt dividends on a state-by-state basis. For some taxpayers, portions of income earned by tax-exempt funds may also be subject to the federal alternative minimum tax.

Even though municipal bond interest may be tax-free, an investor who redeems tax-exempt bond fund shares may realize a taxable capital gain. An investor may also realize a taxable gain from a tax-exempt bond fund if the fund manager sells securities during the year for a net gain.

Tax-Deferred Retirement Accounts

Contributions to certain retirement accounts are tax-deductible and, generally, dividend and capital gain distributions remaining in the accounts accrue tax-deferred until distributed as ordinary income from the account.

In employer-sponsored 401(k) plans, for example, individuals typically contribute pretax dollars from their salaries to an account in the plan. Similarly, Individual Retirement Account (IRA) contributions may be tax-deductible, depending upon a person’s eligibility to participate in an employer-sponsored retirement plan and the individual’s adjusted gross income.

Taxes on mutual fund earnings are deferred when they remain in 401(k) plans, IRAs, and other similar tax-deferred accounts, such as 403(b) accounts. Thus, no tax is incurred as a result of dividend and capital gain distributions, or from the sale of fund shares, until the investor takes distributions from the tax-deferred account.

Distributions are treated as ordinary income, which is subject to the investor’s federal income tax rate at the time of distribution. (Nondeductible or after-tax contributions to these retirement accounts are not subject to taxation at distribution, and distributions from Roth IRAs also may not be subject to taxation at distribution.)

Tax-Advantaged Savings Vehicles

Tax-Deferred Retirement Accounts	Fund investments in certain retirement accounts are tax-deductible and, generally, dividend and capital gain distributions remaining in the accounts (such as IRAs and 401(k) Plans) accrue tax-deferred until distributed as ordinary income from the account.
529 College Savings Plans	529 college savings plans are state-sponsored savings accounts that allow individuals to contribute to an investment account to pay for a student’s future qualified higher education expenses. Earnings on 529 savings plans grow tax-free and earnings withdrawn from 529 savings plans to pay for qualified education expenses are free from federal tax. Mutual funds are the most commonly used investment vehicle in college savings plans.
Coverdell Education Savings Accounts	Formerly known as an Education IRA, a Coverdell Education Savings Account (ESA) is a federally sponsored, tax-advantaged trust or custodial account set up to pay qualified education expenses. Coverdell ESA contributions are not tax-deductible, but amounts deposited in the accounts grow tax-free until withdrawn. Withdrawals from Coverdell ESAs generally are tax-free to the extent that the amount of the withdrawal is not more than the beneficiary’s qualified education expenses.
Health Savings Accounts	Introduced in 2003, Health Savings Accounts (HSAs) allow individuals to make annual contributions to an account in order to cover current or future health care costs. Contributions made to a HSA are tax-free, the account grows tax-free, and withdrawals from the account are tax-free when used to pay for health care costs. In addition, employers can contribute to their employees’ HSAs.

For most investors, distributions from tax-deferred accounts typically begin at or near retirement age, at which time the individual may be in a lower income tax bracket. Investors who receive proceeds from tax-deferred accounts prior to age 59½ may incur a tax penalty in addition to federal, state, and local income taxes.

Types of Distributions

Mutual funds make two types of taxable distributions to shareholders: ordinary dividends and capital gains.

Dividend distributions come primarily from the interest and dividends earned by the securities in a fund’s portfolio and net short-term gains, if any, after expenses are paid by the fund. These distributions must be reported as dividends on an investor’s tax return. Legislation enacted in 2003 lowered the tax on qualified dividend income to 15 percent.

Capital gain distributions represent a fund’s net gains, if any, from the sale of securities held in its portfolio for more than one year. When gains from these sales exceed losses, they are distributed to shareholders. The 2003 legislation also lowered the long-term capital gains tax paid by fund shareholders; in general, these gains are taxed at a 15 percent rate, although a lower rate applies to some taxpayers.

To help mutual fund shareholders understand the impact of taxes on the returns generated by their investments, the SEC adopted a rule that requires mutual funds to disclose standardized after-tax returns for one-, five-, and 10-year periods. After-tax returns, which accompany before-tax returns in fund prospectuses, are presented in two ways:

after taxes on fund distributions only (pre-liquidation); and
after taxes on fund distributions and an assumed redemption of fund shares (post-liquidation).

Share Sales and Exchanges

An investor who sells mutual fund shares usually incurs a capital gain or loss in the year the shares are sold; an exchange of shares between funds in the same fund family also results in either a capital gain or loss (see Tax-Deferred Retirement Accounts for exceptions to these rules).

Investors are liable for tax on any capital gain arising from the sale of fund shares, just as they would be if they sold a stock, bond, or other security. Capital losses from mutual fund share sales and exchanges, like capital losses from other investments, may be used to offset other gains in the current year and thereafter.

The amount of a shareholder’s gain or loss on fund shares is determined by the difference between the “cost basis” of the shares (generally, the purchase price for shares, including those acquired with reinvested dividends) and the sale price. Many funds provide cost basis information to shareholders or compute gains and losses for shares sold.