How Are Withdrawals From Mutual Funds Taxed?

Millions of investors use mutual funds to reach their investment goals. When you make withdrawals from a mutual fund, there will usually be tax consequences. Exactly how your withdrawals will get taxed depends on several factors, each of which we'll consider below.

Taxation of regular mutual fund sales Most of the time, if you want to make a withdrawal from a mutual fund, you have to sell some of the shares that you own. In that case, the usual rules apply governing taxes on the profit or loss that you've earned since you initially purchased the shares. If you have a profit, then you'll realize a capital gain and owe tax. If you have a loss, the resulting capital loss could give you a tax break.

The length of time you own mutual fund shares determines whether the gain or loss is long-term or short-term in nature. Long-term capital gains apply to fund shares held for longer than one year, while fund shares held for a year or less incur short-term capital gains liability. Rates on short-term gains are higher than on long-term gains, so there's an incentive for investors to hold onto shares on which they have a profit.

If you choose to make a partial withdrawal, you have control over some of the tax aspects of the sale. You can specifically identify the shares you want to sell, and if you choose those shares for which you paid the highest amount, your capital gains will be smaller -- or your loss bigger -- than if you choose shares for which you paid less. Also, you can choose shares based on the date you bought them if you want to specify whether you'll pay long-term or short-term capital gains tax rates.

Withdrawals due to fund distributionsSome mutual fund investors set up their accounts so that any distributions that the fund makes are paid to the investor in cash. That resembles a withdrawal, and in that case, the taxation of the amount withdrawn depends on the reason for the distribution. If the fund distributes dividend income that it received, then the applicable tax rate on dividends will apply. If the fund distributes capital gains on fund assets that it sold at a profit, those capital gains get carried out to shareholders within the distributions.

Note that unlike in the capital gains situation, the entire amount of the distribution is typically taxed. That's because the fund only distributes the amount of taxable income, not the full proceeds of any sale that generated that income.

Understanding mutual fund taxation can be confusing. However, it's important to know when an entire withdrawn amount will be subject to tax and when only a portion will be.

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