How are mutual funds taxed?
All mutual funds distributions should be reported as income, whether you reinvest or not. Taxable distributions come in two forms, ordinary dividends and capital gains. The distributions of ordinary dividends represent the net earnings of the fund and are paid out periodically to the shareholders. Since these payments are considered to be dividends to you, they must be accounted for accordingly.
Capital Gain Distributions are the net gains of the sales of securities in the funds portfolio and will be taxed at a different rate than that of ordinary dividends. Yearly, your mutual form will send you a form, called the 1099-DIV, which will have a detailed breakdown of all of these.
Can I avoid tax by reinvesting mutual fund dividends?
Funds will generally give you the opportunity to automatically reinvest in the fund. This does not prevent you from paying tax on your assets, but this reinvestment will prevent you from paying more “buy” fees to get into the fund, so it is advantageous.
What taxes apply to my return-of-capital distributions?
Mutual funds sometimes will distribute back to shareholders monies that haven’t been attributed to the funds earnings. This is a non-taxable distribution.