How are mutual funds taxed?

Dividend distributions pass through what the fund's holdings paid. If those were qualified dividends and you have held the fund long enough, yours are taxed at capital gains rates. If not, they are ordinary income.

Interest distributions come from bond holdings and are ordinary income at your marginal rate, regardless of how long you have held the fund.

Capital gain distributions are the fund passing on gains it realized by selling holdings during the year. These are almost always treated as long-term to you, whatever your own holding period.

The fund's tax position and your own are separate. If the manager sold long-held winners during the year, the fund realized gains, and the law requires it to distribute them.

You receive that distribution and owe tax on it even if the fund's price fell over the same period and your own position is underwater. The distribution also reduces the fund's share price by the amount paid out, so you are not better off, you are simply taxed.

This is the single most common unpleasant surprise in taxable fund investing, and it lands in December when it is too late to do anything about it.

Buy a fund in late November and you may receive a full year of accumulated capital gains in December, taxed to you, on growth that happened before you owned it.

Funds publish estimated distributions in advance, usually from October, on their own websites. Checking that estimate before a large purchase in the last quarter of the year is a two-minute task that occasionally saves a great deal.

If the distribution is large, waiting until after the record date to buy avoids it entirely.

Turnover measures how much of the portfolio the manager trades in a year. High turnover means more realized gains and therefore more distributions.

An index fund tracking a broad market typically has turnover in the single digits and distributes little. An actively managed fund can turn over most of its portfolio annually and distribute a meaningful share of its value.

Turnover is disclosed in the prospectus and on most fund pages. In a taxable account it is arguably more predictive of your after-tax return than the expense ratio.

ETFs largely avoid capital gains distributions because they satisfy redemptions in kind rather than by selling. A broad equity ETF often distributes no capital gains at all.

That is the core of the tax-efficiency argument, and it holds in a taxable account. In a retirement account it is irrelevant, since distributions are not taxed there.

It is not universal either. Bond ETFs distribute interest just like bond funds, and index mutual funds with low turnover behave much like their ETF equivalents.

Separately from distributions, selling fund shares at a profit produces a capital gain, long-term if held more than a year.

Cost basis includes every reinvested distribution, because each one was taxed as income and bought more shares. On a fund held for many years with distributions reinvested, that can be a large share of the basis, and omitting it means paying tax twice.

Mutual funds also allow an average cost basis method, which many providers apply by default and which is generally binding for that holding once used.

Funds that distribute heavily, actively managed equity funds, bond funds, high-yield strategies, cost you more in a taxable account because their returns are taxed annually rather than deferred.

Funds that distribute little, broad index funds and most equity ETFs, sit more comfortably in a taxable account.

Placing assets deliberately across your taxable and retirement accounts costs nothing and compounds. It is the highest-return tax decision most investors never make.

Distribution classification, holding periods and 1099 reporting are in IRS Publication 550. Capital gains rates and holding periods are in IRS Topic 409. Walnut is informational and is not an investment adviser. This guide is educational and not personalized tax or investment advice; anything with a tax consequence is worth confirming with a tax professional.