Any Tax Benefits to Reinvesting Your Dividends from Mutual Funds?

For the most part, mutual fund companies allow investors to reinvest their dividends, and many investors take advantage of this perk. When dividends are invested, they can be used the same as cash to purchase additional shares of the fund to further your interest. This essentially means two things for investors:

1. The reinvested dividends are considered to be an additional purchase, which means there will be an increase in the cost basis of your investment in the mutual fund.

2. You are required to report the reinvested dividend just as you would if you received it in the form of cash.

There can be a variety of income associated with mutual funds, and each type is subject to a different type of tax. The majority of these taxes are paid by the investor of the fund. For example, if a mutual fund holds stocks for more than a year, then sells them for a profit, part of the dividend payout may be treated as a long term capital gain. This will actually result in a lower tax rate. Distributions from mutual funds fall into the following classes:

Ordinary Dividends: These include all forms of income that is taxable, except for long term capital gains. While these dividends are not necessarily taxed at ordinary rates, they do include those that are taxed lower.

Capital Gain Distributions:  Some mutual funds include long term capital gains in their distributions. This portion of the dividend typically receives a more favorable tax rate. If there are only short term capital gains, they are included in ordinary dividends.

Federal Interest Distributions:  If the mutual fund you invest in invests in government obligations, you may be able to treat at least some of your distributions as federal government interest. This does not allow you any breaks on your federal income tax returns, but they are not subject to state taxes.

Non-Dividend Distributions:  There are times when mutual fund payments do not represent even tax exempt income. They are simply distributing the money you have already invested. These payments do not have to be reported, they just have to be used to adjust the basis to figure your total gain or loss when selling.

Exempt Interest Distributions:  If you invest in a mutual fund that invests in government bonds or obligations, some of the distributions may be classified as exempt interest. While these payments are not included in your overall taxable income, they may affect other income such as from bonds or Social Security, or require you pay an alternative minimum tax.

Tags: capital gain, distributions, dividends, interest, tax