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The mutual funds you hold in your portfolio don't change much on appearance, but the positions within can change frequently during the course of the year as the fund managers close out positions that no longer meet the risk tolerance or objectives of the fund and begin realizing some gains. If you hold these mutual funds in a nonqualified account, get ready to pay taxes on the capital gains as well as any dividend or interest paid to the funds.

The Mutual Fund Pass Through

Any interest income, dividends, or gains made by a mutual fund are passed through to the shareholders. Shareholders are taxed on these various types of gains the same way they would be if they were for individual stocks in their account. For example, if a mutual fund receives qualified dividends, then each shareholder is responsible to pay taxes on their share of the qualified dividends. Likewise, capital gains made by the fund are taxed to shareholders just as long-term gains in their accounts would be.

What Doesn't Pass Through

Unfortunately for shareholders, losses within the mutual fund do not pass through and, thus, are not tax-deductible against gains.

How Tax Rates Apply

No matter what the source of the gain was, a mutual fund distribution is reported on Form 1099-DIV. It will be reflected on the form as a dividend, interest or capital gains distribution, and this will affect your tax liability.

• Long-term capital gain distributions are taxed at capital gains rates even if you bought into the fund less than one year ago.
• Short-term capital gain distributions are taxed just as ordinary, non-qualified dividends, which means they’re taxed at your ordinary income tax rate.
• Qualified dividend distributions are taxed at long-term capital gains rates, as long as you meet holding requirements.
• Taxable interest distributions are taxed at ordinary income tax rates.
• Distributions from a tax-exempt bond fund may be federal tax exempt, however the shareholder still must report them and may be required to pay state and local taxes on them.

By reviewing the prospectus and finding the turnover ratio of any fund you plan to buy, you can get an idea of the likelihood of having to pay on taxable gains. It’s not unusual for certain managed funds to have an 85 percent turnover ratio, ensuring distributions annually. Some funds have turnover ratios as high as 800 percent, resulting in unusually high commissions and fees within the funds as well as taxable distributions.