Who Pays Taxes On Fund Distributions?

I detect a bit of confusion among certain of my subscribers regarding who pays taxes on capital gains of stock sold during a given year by fund managers.

A couple of folks asked why shareholders had to pay taxes on those gains when the “fund” had already paid them. Well, first of all, the fund hasn’t already pay taxes on those distributions.

Shareholders Pay

Shareholders of the funds – you – end up with the tax bill. And you pay taxes on those distributions whether or not the distributions are reinvested in additional fund shares or received in cash. To clarify, let’s venture behind the scenes to see what actually happens.

Federal law requires fund managers to distribute all dividends, interest and capital gains to shareholders…and report those distributions to you as they occur, typically quarterly and at year-end for dividends and capital gains… and monthlyfor interest.

Although it’s common – and wise – for shareholders to automatically reinvest distributions in additional shares of the mutual fund, that doesn’t eliminate their obligation to pay taxes on such distributions quarterly or by no later than April 15 of the following year. In short, shareholders are responsible for reporting such distributions on their next year’s federal tax return and for paying any tax due, when due.

Tax-Deferred Exception

If a mutual fund is held in a tax-deferred account (i.e., a 401(k), IRA, etc.), the rules regarding distributions are different than as explained above. In tax-deferred cases – those funded with pre-tax contributions – with few exceptions, shareholders will be taxed when the money is withdrawn from such accounts – whether voluntarily or as Required Minimum Distributions (RMDs).

However if the account is a Roth IRA or a Roth 401(k), shareholders won’t be taxed on withdrawals since those accounts are funded with after-tax contributions. And there’s a different set of rules, maybe even penalties, covering “early” withdrawals, but that’s another story.

To Recap: You Pay

To recap, mutual fund entities do not pay taxes on capital gains, interest and dividends earned by their shareholders. That’s a shareholder’s obligation. So, keep detailed records of all mutual fund distributions – and on your own purchases and sales of fund shares. And report these activities without fail to Uncle Grabby.

Remember, the mutual fund company has already reported the distributions to Uncle Grabby on a 1099-DIV. And Grabby’s watching to make sure you, the shareholder, reports those same distributions on your federal tax return.