A basic knowledge of mutual fund taxation and careful record-keeping can help you cut the tax bite on your mutual fund investments.

Note: The fund itself is not taxed on its income if certain tests are met and substantially all of its income is distributed to its shareholders.

There are two types of taxable distributions: (1) ordinary dividends and (2) capital gain distributions.

Ordinary Dividends. Distributions of ordinary dividends, which come from the interest and dividends earned by securities in the fund’s portfolio, represent the net earnings of the fund. They are paid out periodically to shareholders. Like the return on any other investment, mutual fund dividend payments decline or rise from year to year, depending on the income earned by the fund in accordance with its investment policy. Because these payments are considered dividends to you, they must be reported on your tax return. As qualified dividends, they will enjoy the special low tax rate granted dividends in the 2003 Tax Act: specifically, a tax rate of 15% (except 5% for taxpayers in tax brackets below 25% and 0 for those taxpayers in 2008).

Qualified dividends are, with certain exceptions, dividends received from domestic and foreign corporations after 2002 and before 2009—even including dividends received in 2003 before the 2003 Act was enacted (late May). Dividends from foreign corporations are qualified where their stock or ADRs are traded on U.S. exchanges or with IRS approval where the dividends are covered by U.S. tax treaties. Dividends from mutual funds qualify where a mutual fund is receiving qualified dividends and distributing the required proportions thereof.

Capital gain distributions. When gains from the fund’s sales of securities exceed losses, they are distributed to shareholders. As with ordinary dividends, these capital gain distributions vary in amount from year to year. They are treated as long-term capital gain, regardless of how long you have owned your fund shares.

A mutual fund owner may also have capital gains from selling mutual fund shares.

Capital gains rates. Two different sets of long-term capital gains rates apply for capital gains distributions and for sales of mutual fund shares during 2003, making an already complicated rule more complicated. The beneficial long-term capital gains rates on sales of mutual fund shares apply only to profits on shares held more than a year before sale. (Profit on shares held a year or less before sale is ordinary income, but capital gain distributions are long-term regardless of the length of time held before the distribution.)

Before 5/6/03. For capital gains distributions received before 5/6/03 and for gains on shares held long-term (more than a year) when sold before 5/6/03, the tax rate is 20% of net gain (except 10% if the taxpayer is otherwise below the 25% bracket). See also 5-year rule below.

After 5/5/03. For capital gains distributions received after 5/5/03 and for gains on shares held long-term (more than a year) when sold after 5/5/03, the tax rate is 15% of net gain (except 5% if the taxpayer is otherwise below the 25% bracket). The 15%/5% rates apply through 2008, except that the 5% rate becomes 0 in 2008. The rates revert to 20% and 10% (as before 5/6/03) in 2009 and 2010, with an 18% rate for certain assets held more than 5 years, see below.

A further complication, which works in taxpayers’ favor, is this: Say your taxable income, apart from long-term capital gains and qualified dividends, puts you in a tax bracket below 25% (that’s below $56,800 on a joint return). In this case you’ll get the benefit of the lower rate (10% for pre 5/6/03 long-term gains, 5% for post 5/5/03 long-term gains and 2003 dividends whenever received) on the amount of gain between your taxable income and the start of your 25% bracket. See Examples below under “Computing 2003 capital gains tax.”

5-year rule. Taxpayers below the 25% bracket who sold, before 5/6/03, assets held more than 5 years qualify for an 8% capital gains rate on such sales. For sales after 5/5/03 and before 2009, the 5% rate applies (0 for 2008).

18% capital gains rate after 2008. Mutual fund stock gains otherwise taxable at a 20% rate after 2008 will be taxed at 18%, if the stock was acquired or treated as acquired after 2000 and held more than 5 years.

Stock whose ownership began before 2001 is treated as if acquired after 2000 if the taxpayer so elected. Under the election the taxpayer reported as if the stock was sold January 2, 2001 for its fair market value (FMV) on that date, and reported gain accordingly. The stock is then treated as acquired on that date, for that FMV.

The effect of the election is to lower by 2 percentage points (from 20% to 18%) the capital gains tax rate otherwise scheduled to return after 2008, at the cost of a current (2001) tax on paper gains. Since paying a tax in one year in order to obtain a tax benefit in later years seemed a questionable enterprise, this Financial Guide at the time urged caution in making the election. It has turned out that the election does no good for sales before 2009, where the tax rate has been reduced to 15% anyway. The election is irrevocable and no provision has been made to refund tax paid. The election will be useful, assuming no further law change, only for sales after 2008.

Mutual fund distributions are generally taxable in the year paid. At tax time, your mutual fund will send you a Form 1099-DIV, which tells you what earnings to report on your income tax return, and how much of it is post 5/5/03. Because tax rates on qualified dividends received after 2002 are the same as for capital gains distributions and long-term gains on sales after 5/5/03, Congress wants these items combined in your tax reporting—that is, qualified dividends added to long-term capital gains. Lest anyone think this makes reporting easier, remember that gains and distributions before 5/6/03 will not be included (meaning that such gains for the period 1/1/03—5/5/03 will be taxed higher than dividends received in that period). Also, capital losses are netted against capital gains before applying the favorable capital gains rates. Losses will not be netted against dividends.

Computing 2003 capital gains tax

Example (1): Don and Joan have $51,800 in taxable income on their joint return, plus $40,000 from capital gains distributions and sales of mutual fund shares, all after 5/5/03. Tax on the gain is $5,500, which is composed of $250 (5% of that part of the gain within the spread from their taxable income to where the 25% bracket begins) plus $5,250, which is 15% of the balance of the gain.