Important Change
Reporting interest and dividends. Interest or ordinary dividend income that exceeds a certain amount must be reported on a separate schedule. For 2002, this amount has increased. If you file Form 1040A, you must now attach Schedule 1 to your return if your interest or dividend income is more than $1,500; if you file Form 1040, you must now attach Schedule B to your return if your interest or dividend income is more than $1,500. Before 2002, you had to attach Schedule 1 or Schedule B if your interest or dividend income was more than $400.
Important Reminders
8% capital gain rate. The 10% capital gain rate is lowered to 8% for qualified 5-year gain. See Capital Gain Tax Rates, later.
10% capital gain rate. Beginning in 2006, the 20% capital gain rate will be lowered to 18% for qualified 5-year gain. The holding period for the property sold must have begun after 2000.
Photographs of missing children. The Internal Revenue Service is a proud partner with the National Center for Missing and Exploited Children. Photographs of missing children selected by the Center may appear in this publication on pages that would otherwise be blank. You can help bring these children home by looking at the photographs and calling 1-800-THE-LOST (1-800-843- 5678) if you recognize a child.
Introduction
This publication provides federal income tax information for individual shareholders of mutual funds, including money market funds. It explains how to report distributions paid to you by a mutual fund and any expenses connected with your investment. In addition, it explains how to report undistributed long-term capital gains. It also explains how to figure and report your gain or loss when you sell, exchange, or redeem your mutual fund shares. A comprehensive example, with filled-in forms, appears at the end of the publication.
Mutual fund. A mutual fund is a regulated investment company generally created by pooling funds of investors to allow them to take advantage of a diversity of investments and professional management.
Money market fund. A money market fund is a mutual fund that tries to increase current income available to shareholders by buying short-term market investments.
Money market funds pay dividends and should not be confused with bank money market accounts that pay interest.
Qualified retirement plans and IRAs. The rules in this publication do not apply to mutual fund shares held in individual retirement arrangements (IRAs), H.R. 10 (Keogh) plans, section 401(k) plans, and other qualified retirement plans. The value of the mutual fund shares and earnings allocated to you are included in your retirement plan assets and stay tax free generally until the plan distributes them to you. The tax rules that apply to retirement plan distributions are explained in the following publications.
- Publication 560, Retirement Plans for Small Business (SEP, SIMPLE, and Qualified Plans).
- Publication 571, Tax-Sheltered Annuity Plans (403(b) Plans).
- Publication 575, Pension and Annuity Income.
- Publication 590, Individual Retirement Arrangements (IRAs).
- Publication 721, Tax Guide to U.S. Civil Service Retirement Benefits.
Comments and suggestions. We welcome your comments about this publication and your suggestions for future editions.
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Internal Revenue Service
Tax Forms and Publications
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We respond to many letters by telephone. Therefore, it would be helpful if you would include your daytime phone number, including the area code, in your correspondence.
Useful Items You may want to see:
Publication
- 550 Investment Income and Expenses
Form (and Instructions)
- Schedule B (Form 1040) Interest and Ordinary Dividends
- Schedule D (Form 1040) Capital Gains and Losses
- Schedule 1 (Form 1040A) Interest and Ordinary Dividends for Form 1040A Filers
- 1099-B Proceeds from Broker and Barter Exchange Transactions
- 1099-DIV Dividends and Distributions
- 2439 Notice to Shareholder of Undistributed Long-Term Capital Gains
- 4952 Investment Interest Expense Deduction
See How To Get Tax Help near the end of this publication for information about getting these publications and forms.
Tax Treatment of Distributions
A distribution you receive from a mutual fund may be an ordinary dividend, a capital gain distribution, an exempt-interest dividend, or a nontaxable return of capital. The fund will send you a Form 1099-DIV or similar statement telling you the kind of distribution you received. This section discusses the tax treatment of each kind of distribution, describes how to treat reinvested distributions, and explains how to report distributions on your return.
You may be treated as having received a distribution of capital gains even if the fund does not distribute them to you. See Undistributed capital gains under Capital Gain Distributions.
Community property states. If you are married and receive a distribution that is community income, one-half of the distribution is generally considered to be received by each spouse. If you file separate returns, you must each report one-half of any taxable distribution. Get Publication 555, Community Property, for more information on community income.
If the distribution is not considered community income under state law and you and your spouse file separate returns, each of you must report your separate taxable distributions.
Share certificate in two or more names. If two or more persons, such as you and your spouse, hold shares as joint tenants, tenants by the entirety, or tenants in common, distributions on those shares are considered received by each of you to the extent provided by local law.
Certain year-end dividends received in January. Dividends declared and made payable by mutual funds in October, November, or December are considered received by shareholders on December 31 of the same year even if the dividends are actually paid during January of the following year.
Tax-exempt mutual fund. Distributions from a tax-exempt mutual fund (one that invests primarily in tax-exempt securities) may consist of ordinary dividends, capital gain distributions, undistributed capital gains, or return of capital like any other mutual fund. These distributions generally are treated the same as distributions from a regular mutual fund.
Distributions designated as exempt-interest dividends are not taxable. (See Exempt-Interest Dividends, later.)
Ordinary Dividends
An ordinary dividend is a distribution by a mutual fund out of its earnings and profits. Include ordinary dividends that you receive from a mutual fund as dividend income on your individual income tax return.
Ordinary dividends are the most common type of dividends. They will be reported in box 1 of the Form 1099-DIV or on a similar statement you receive from the mutual fund.
Capital Gain Distributions
These distributions are paid by mutual funds from their net realized long-term capital gains. The Form 1099-DIV (box 2a) or the fund's statement will tell you the amount you are to report as a capital gain distribution. Capital gain distributions are taxed as long-term capital gains regardless of how long you have owned the shares in the mutual fund.
Undistributed capital gains. Mutual funds may keep some of their long-term capital gains and pay taxes on those undistributed amounts. You must report your share of these amounts as long-term capital gains, even though you did not actually receive a distribution. You can take a credit for any tax paid because you are considered to have paid it.
Form 2439. The fund will send you Form 2439, instead of Form 1099-DIV, showing your share of the undistributed long-term capital gains in box 1a and any tax paid by the mutual fund in box 2. Attach Copy B of Form 2439 to your return.
Increase to basis. When you report undistributed capital gains from a mutual fund, you must increase your basis in the shares. You must keep Copy C of Form 2439 to show this increase. See Adjusted Basis, later.
Exempt-Interest Dividends
A mutual fund may pay exempt-interest dividends to its shareholders if it meets certain requirements. These dividends are paid from tax-exempt interest earned by the fund. Since the exempt-interest dividends keep their tax-exempt character, do not include them in income. However, you may need to report them on your return. See Information reporting requirement, next. The mutual fund will send you a statement within 60 days after the close of its tax year showing your exempt-interest dividends. Exempt-interest dividends are not shown on Form 1099-DIV.
Information reporting requirement. Although exempt-interest dividends are not taxable, you must report them on your tax return if you are required to file. This is an information reporting requirement and does not convert tax-exempt interest to taxable interest. Also, this income is generally a tax preference item and may be subject to the alternative minimum tax. If you receive exempt-interest dividends, you should get Form 6251, Alternative Minimum Tax - Individuals, for more information.
Reporting Mutual Fund Distributions on Form 1040 and Form 1040A
Return of Capital (Nontaxable) Distributions
A distribution that is not out of earnings and profits is a return of your investment, or capital, in the mutual fund and is shown in box 3 of Form 1099-DIV. These return of capital distributions are generally not taxed and are sometimes called tax-free dividends or nontaxable distributions.
A return of capital distribution reduces your basis in the shares. Basis is explained under Keeping Track of Your Basis, later. Your basis cannot be reduced below zero. If your basis is zero, you must report the return of capital distribution on your tax return as a capital gain. Report this capital gain on Schedule D (Form 1040). Whether it is a long-term or short-term capital gain depends on how long you held the shares.
Example. You bought shares in a mutual fund in 1998 for $12 a share. In 1999, you received a return of capital distribution of $5 a share. You reduced your basis in each share by $5 to an adjusted basis of $7. In 2000, you received a return of capital distribution of $1 per share and further reduced your basis in each share to $6. In 2001, you received a return of capital distribution of $2 per share. Your basis was reduced to $4. In 2002, the return of capital distribution from the mutual fund was $5 a share. You reduce your basis in each share to zero and report the excess ($1 per share) as a long-term capital gain on Schedule D.
Reinvestment of Distributions
Most mutual funds permit shareholders to automatically reinvest distributions in more shares in the fund, instead of receiving cash. You must report the reinvested amounts the same way as you would report them if you received them in cash. This means that reinvested ordinary dividends and capital gain distributions generally must be reported as income. Reinvested exempt-interest dividends generally are not reported as income. Reinvested return of capital distributions are reported as explained under Return of Capital (Nontaxable) Distributions, earlier. See Keeping Track of Your Basis, later, to determine the basis of the additional shares.
How To Report
You must report mutual fund distributions on Form 1040 or Form 1040A. You cannot report mutual fund distributions on Form 1040EZ.
You cannot use Form 1040A and must use Form 1040 in either of the following situations.
- You received a return of capital distribution that must be reported as a capital gain because it is more than your basis in your mutual fund shares.
- You must report an undistributed capital gain.
Form 1040A. If you file Form 1040A, report your ordinary dividend distributions on line 9 and your exempt-interest dividends on line 8b. If the total of the ordinary dividends you received is more than $1,500 or you received ordinary dividends as a nominee, first report the ordinary dividends in Part II of Schedule 1, on line 5. Report the total from line 6 of that schedule on line 9 of Form 1040A. Attach Schedule 1 to your return.
Capital gain distributions. If you received capital gain distributions, you may have to file Form 1040. But you can report capital gain distributions on line 10 of Form 1040A, instead of on Form 1040, if both of the following are true.
- None of the Forms 1099-DIV (or substitute statements) you received have an amount in box 2b, 2c, 2d, or 2e.
- You do not have to file Form 1040 for any other reason. (For example, you must not have any other capital gains or any capital losses.)
Form 1040. If you file Form 1040, report your ordinary dividend distributions on line 9 and your exempt-interest dividends on line 8b. If the total of the ordinary dividends you received is more than $1,500 or you received ordinary dividends as a nominee, first report the ordinary dividends in Part II of Schedule B, on line 5. Report the total from line 6 of that schedule on line 9 of Form 1040. Attach Schedule B to your return.
Do not include capital gain distributions as dividend income on Form 1040 or Schedule B.
Capital gain distributions. If you received capital gain distributions, you report them either directly on Form 1040, line 13, or on Schedule D, line 13, depending on your situation. Report them on Schedule D, line 13, unless all of the following are true.
- The only amounts you would have to report on Schedule D are capital gain distributions from box 2a of Form 1099-DIV (or similar statement).
- You do not have an amount in box 2b, 2c, 2d, or 2e of any Form 1099-DIV (or similar statement).
- You are not filing Form 4952 or, if you are, the amount on line 4e of that form is not more than zero.
If all of the above statements are true, report your capital gain distributions directly on line 13 of Form 1040 and check the box on that line. Also use the Capital Gain Tax Worksheet in the Form 1040 instructions to figure your tax.
Undistributed capital gains. To report undistributed capital gains, you must complete Schedule D and attach it to your return. Report these gains on Schedule D, line 11, and attach Copy B of Form 2439 to your return. Report the tax paid by the mutual fund on these gains on Form 1040, line 68, and check box a on that line.
Tables 1A and 1B. See Tables 1A and 1B for more information on where to report your mutual fund distributions on Form 1040 or Form 1040A.
Nominees. If you received a Form 1099-DIV or Form 2439 as a nominee (that is, it includes amounts that actually belong to someone else, other than your spouse), you must file a Form 1099-DIV or Form 2439 with the Internal
Revenue Service and give the actual owner a copy. See the instructions for Forms 1099 or Form 2439 for details.
If you received an ordinary dividend distribution as a nominee, report it on line 5 of Schedule B (Form 1040) or Schedule 1 (Form 1040A). Under your last entry on line 5, put a subtotal of all ordinary dividends listed. Below this subtotal, enter Nominee Distribution and show the total ordinary dividends you received as a nominee. Subtract this amount from the subtotal and enter the result on line 6.
If you received a capital gain distribution or were allocated an undistributed capital gain as a nominee, report only the amount that belongs to you on line 10 of Form 1040A, line 13 of Form 1040, or Schedule D (Form 1040), whichever is appropriate. Attach a statement to your return showing the full amount you received or were allocated and the amount you received or were allocated as a nominee.
Foreign tax deduction or credit. Some mutual funds invest in foreign securities or other instruments. Your mutual fund may choose to allow you to claim a deduction or credit for the taxes it paid to a foreign country or U.S. possession. The fund will notify you if this applies to you. The notice will include your share of the foreign taxes paid to each country or possession and the part of the dividend derived from sources in each country or possession.
You may be able to claim a credit for income tax paid to a foreign country. However, it may be to your benefit to treat the tax as an itemized deduction on Schedule A (Form 1040). For more information on claiming a foreign tax deduction or credit, get Publication 514, Foreign Tax Credit for Individuals.
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