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What You Need to Know About Paying Taxes on Your Mutual Fund

Howard Hook, CFP®, CPA, quoted in NJMoneyHelp on March 23, 2015

The Question: I understand that distributions paid by mutual funds are exempt from New Jersey income tax “to the extent the distributions are attributable to interest earned on Federal obligations.” I received a 2014 1099-DIV for a mutual fund I own which showed dividends and capital gains distributions, along with a statement that 5 percent of the fund’s total income was derived from U.S. government obligations. On my New Jersey tax return can I exclude 5 percent of the dividends and also 5 percent of the capital gains shown on my 1099-DIV? Note that the capital gains are not due to the sale of my own shares of the mutual fund.

The Answer: That would be nice, wouldn’t it?

The federal government and state governments have agreements to not tax interest earned on one another’s investments, said Eric Furey.

“What this means is, the Federal government won’t tax interest earned from New Jersey based investments (municipal bonds), and New Jersey won’t tax interest earned from investments issued by the Federal government (Treasury bonds),” Furey said.

But as you may see, some mutual funds hold municipal bonds and Treasury bonds which can complicate someone’s tax situation. The types of income one will see on their annual tax reports are dividends, capital gain distributions and appreciation, Furey said.

“Dividends are paid regularly as the fund company is simply passing the income they receive onto shareholders,” he said. “For example, if a mutual fund owns shares of Exxon Mobil and Exxon paid a dividend then the mutual fund will pass that dividend along to shareholders.”

Capital gain distributions are paid toward the end of the year, he said. Similar to individual investors, mutual fund companies buy and sell stocks throughout the year. When they sell stocks at a gain, then they need to distribute that gain to shareholders so tax can be paid.

“These capital gain distributions can come in two forms – short-term and long-term capital gains,” Furey said. “Short-term capital gain distributions occur when a stock is held for less than one year. Long-term capital gain distributions occur when a stock is held for more than a year.”

The length of time the investment is held will impact the tax rate you’d pay on the gain.

Mutual funds are considered pass-through entities, which means they do not pay income tax on the earnings of the fund (income and capital gains) but instead pass the income through to the shareholders of the fund, who then pay tax on the income and capital gains, said Howard Hook, a certified financial planner and certified public accountant with EKS Associates in Princeton.

Capital gain distributions, however, are not state tax exempt, Hook said. This is because the gain resulted from a sale of the bond that exceeded the cost of the bond and not through the payment of income.

“If you sold the Treasury Bond which you paid $10,000 for $11,000, you would realize a $1,000 capital gain which would be taxable for both federal and state,” Hook said. “If the bond was owned by a mutual and sold, the capital gain would still be taxable to you as the owner of the mutual fund.”

Hook said this is regardless of whether or not you sold actual shares of the mutual fund.