How Mutual Fund Investments Are Taxed

Since your goal as an investor should be to keep as much as possible of what you
earn from mutual fund investments, you can't look past the inescapable reality
that taxes take a big bite out of bottom-line returns.

Owning Shares and Paying Taxes

A mutual fund is not taxed on the income or profits it earns on its investments as
long as it passes those earnings along to shareholders. The shareholders, in turn,
pay any taxes due. The two types of distributions that mutual funds make are
income distributions and capital gains distributions:

Income distributions represent all interest and dividend income earned by securities, 
whether cash investments, bonds, or stocks, after subtracting the fund's operating 
expenses. Capital gains distributions represent the profit a fund makes when it
sells securities. When a fund makes such a profit, a capital gain is realized.
When a fund sells securities at a price lower than it paid, it realizes a
capital loss. If total capital gains exceed total capital losses, the fund has
net realized capital gains, which are distributed to fund shareholders. Net realized 
capital losses are not passed through to shareholders but are retained by the fund 
and may be used to offset future capital gains. 

Occasionally distributions from mutual funds may include a return of capital.
Returns of capital are not taxed (unless they exceed your original cost basis)
because they are considered a portion of your original investment being returned
to you.

Generally, all income and capital gains distributions are subject to federal income
taxes (and often state and local taxes as well). You must pay taxes on
distributions regardless of whether you receive them in cash or reinvest them in
additional shares. The exceptions to the general rule are:

U.S. Treasury securities, whose interest income is exempt from state income taxes. 
Municipal bond funds, whose interest income is exempt from federal tax and may be 
exempt from state taxes as well. 

However, any capital gains on U.S. Treasury securities or municipal bond funds
are generally taxable.

While the amount of income and capital gains you receive from a mutual fund
affects the taxes you pay, another important factor is the holding period for
capital gains or losses, that is, how long the securities are held before they are
sold or exchanged. Securities that are held for one year or less before they are
sold or exchanged are categorized as short-term capital gains (or losses).