Mutual Funds and the new tax Law

Recent changes in the US tax code reduced the tax rate on dividends.  Mutual fund investors know that they pay dividends, but that doesn’t necessarily mean your fund dividends will now be non-taxable.  On the contrary, depending upon the type of fund you own, your tax liability may barely change.  Let me explain.

As it stands now, corporations pay income taxes on their profits, and until the law passed, if they then paid out a dividend to their shareholders, that dividend would be subjected to income taxes too.  That was double taxation.  The law was changed to stop the shareholder from having to pay income taxes on the stock dividends received.

However mutual fund dividends have several possible components to them.  If your fund owns stocks, and some of them pay dividends, that portion of your fund dividend that represents true stock dividends will be tax exempt.  For most funds, dividend income is not a major portion of the fund dividend that is paid out to shareholders.  

Mutual funds also include capital gains distributions, both long and short term, as part of their regular dividend.  A third component of a fund dividend is interest from securities, such as bonds, that pay interest.   Interest is not a dividend and is still subject to being taxes as regular income.

Thus it is possible to have a mutual fund dividend comprised of stock dividends, interest, short and long term capital gains.  You will need to keep track of these different types of income for your income taxes, and for when it is time to ascertain your cost basis for shares sold.

To complicate matters further, another quirk to the new law is that corporations that choose to retain earnings, rather than pay it out to shareholders as dividends can credit shareholders for the tax exemption they would have received if those earnings had indeed been paid out.   This retained exemption can then be used to lower the capital gains due when the stock is sold.  Mutual fund companies will have to track this information for you as well.  If you don’t keep track of the “phantom stock dividend exemption,” then you will pay more in capital gains then you have to.

That all adds up to 4 different types of income possible from your fund distributions to keep up with.

One way to simplify this is to hold your funds in either a qualified account (retirement account or pension) or to purchase a variable or fixed annuity. 

For more information on how you can save money on your taxes in retirement, order our free booklet, “Seven Ways Retirees Can Cut Taxes,” by clicking here.