When you invest in a mutual fund, the fund you own may pay distributions to your account. You will owe tax on these distributions in the year they are received unless you own the fund shares in a tax-deferred account, such as an IRA or 401(k).

Types of Distributions
How You're Taxed
Strategies That May Reduce Your Tax Liability

Types of Distributions
Mutual funds must distribute at least 98% of their annual income to investors for the funds to avoid taxation. Funds may distribute four types of income, based on their investments.

Long-term capital gain distributions: When a mutual fund makes a profit from the sale of investments in its portfolio, it generally passes the profit on to you in the form of capital gains. Long-term capital gains are gains on securities owned by the fund for more than one year.

Ordinary income distributions: A mutual fund earns dividends, interest and other investment income on the securities in which it invests. After a fund subtracts its expenses from the investment income, it distributes the remainder to you as an ordinary income distribution.

The IRS requires that ordinary income distributions include any short-term capital gains (gains on securities owned by the fund for one year or less) realized and distributed by the fund.

Qualified dividend distributions: A special category called “qualified dividends” applies to dividends paid on stock investments. The mutual fund will pass through to investors any qualified dividends it receives from stocks in the fund’s portfolio.

Tax-exempt dividend distributions: Interest from state and local municipal bonds is exempt from federal taxes and generally is exempt from state taxes in the state in which the bonds were issued. Mutual funds that invest in these securities generally distribute tax-exempt dividends to their investors.

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How You're Taxed
Distributions generally are subject to federal income taxes and may be subject to state and local taxes, whether you reinvest them or take them in cash. The tax status of a capital gain distribution is determined by how long the mutual fund held the underlying security that was sold, not by how long you have been invested in the fund.

• Long-term capital gains: Your tax bracket determines how much tax you will owe on long-term capital gain distributions, as shown in the table below.
• Ordinary income distributions: This category also includes short-term capital gains. You will owe tax on these distributions at the rate of your ordinary income tax bracket.
• Qualified dividend distributions: Qualified dividends are taxed at the long-term capital gain rates through 2008, as shown in the table below. To qualify for these reduced rates, you must own the mutual fund shares for a period of 61 days or longer. That period must include the date the fund distributed the dividends.
• Tax-exempt dividend distributions: While the dividends may be tax exempt, a portion of the income may be an adjusting item for the Alternative Minimum Tax. It also is possible to have taxable capital gains from investing in tax-exempt bond funds since bond prices fluctuate in response to changing interest rates. By selling bonds at a profit, a fund can generate capital gain distributions that may be subject to federal and state income taxes.

*The rates and rules for long-term capital gain tax rates change beginning in 2009.

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Strategies That May Reduce Your Tax Liability
Here are a few tips that may help you minimize your taxes from distributions:

• Avoid buying shares in a mutual fund right before a capital gain distribution. Although the distribution may seem like an immediate payback, you’re really buying a tax liability. Here’s why: Say you buy shares in a fund with a net asset value (NAV) of $30 per share. The NAV includes a realized net capital gain of $3 per share. As soon as the fund distributes the $3, the NAV drops to $27. You now have an investment worth $27 per share plus a $3 distribution, and you will owe tax on that $3. While your investment is still worth $30 per share if you reinvest the distribution, you’ve also gained a tax bill.
• Ask the fund company for estimated distributions and unrealized gains per share for your fund. This information can help you determine how potential distributions could affect your tax bill.
• Consider tax-efficient funds. Two important considerations are the securities a fund invests in and the fund's investment philosophies.
• Offset capital gains with capital losses. You may be able to use capital losses from one investment to offset capital gains from another, dollar for dollar. You also can use losses to offset up to $3,000 in other ordinary income each year. You can use any unclaimed portion to offset gains and income in later years.
• Transfer mutual fund shares that get a large distribution to a charitable organization. When you donate appreciated securities to a charity, you avoid paying taxes on distributions if the transfer takes place before the record date – the day the fund determines which investors receive capital gain and income distributions. Consult your tax advisor about your specific situation.

Taxes should never be the only—or even the most important—consideration when investing in mutual funds. You should look for funds that have solid management and good track records and that meet your long-term investment strategy. These features are more likely to help you meet your financial goals, even considering the cost of taxes.

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This information is for educational purposes only and is not intended as investment or tax advice.

This article is from the Financial FYI^® series produced by the Investor Education department of American Century Investments. "Financial FYI" is a registered mark of American Century Proprietary Holdings, Inc.

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