You probably hold at least one mutual fund in your investment portfolio, and while you are hoping to make huge gains on your investment, these funds often have different tax liabilities associated with them.

The way your mutual fund is treated for tax purposes has a lot to do with the type of investments in your portfolio.

For the purpose of this article, we will be primarily discussing the taxation involved with dividend distributions.

What are Dividend Distributions and How are they Taxed?

A dividend is a distribution of a company’s profits to its shareholders. Mutual funds holding dividend paying stocks or bonds must make dividend distributions to all its shareholders.

If your mutual fund buys and sells dividend paying stocks, generally, any dividends you receive are taxed as ordinary income. Assume you received $100 in dividend payments from your actively managed fund. If you belong to the 22% tax bracket, you owe the IRS $22 at the end of the financial year.

These dividend distributions may be subject to capital gains tax if the dividend is paid by a U.S. stock or qualified foreign corporation and your mutual fund has held the stock for more than 60 days before the ex-dividend date or a combination of days before and after the ex-dividend date, adding to 60 days.

These dividends must be reported on Form 1099-DIV. However, not all dividend distributions are taxed.

What are Exempt-Interest Dividends?

Paying taxes on your capital gains or dividend distributions is not the goal you had in mind when starting your investments, and one way to minimize your tax bill is to invest your money in tax-free mutual funds.

These funds are primarily focused on government or municipal bonds and can offer tax-free dividend distributions. They are considered stable and safe investments, offering a low rate of return. However, the rules for tax exemptions are different for each state that issued the bonds.

An exempt-interest dividend is a distribution from a mutual fund that is not subject to federal income tax. While exempt-interest dividend distributions are not subject to federal income tax, they may still be subject to State income tax or Alternative Minimum Tax (AMT).

Why Exempt-Interest Dividends?

While there are no limitations on who can invest in government or municipal bonds, they are primarily suitable for taxpayers in high income tax brackets. If you are in a high income tax bracket, these investments, even with their low rate of return can reward you with great tax savings.

If you are a high-net-worth investor and looking for a way to reduce your federal tax bill, include a mix of municipal bonds that support municipalities in your state of residence. Interest payments from these municipal bonds will be exempt-interest dividends.

Do Exempt-Interest Dividends need to be Reported?

Yes.

Mutual funds are required to report exempt-interest dividends on Form 1099-DIV. While this is a dividend form, you will have to report it as exempt interest along with any other exempt interest you may have received for the year.

Will reporting this income make it taxable?

No.

Reporting income from exempt-interest dividends will not cause it to be taxable, but you are required to report it anyway.

Considerations for Exempt-Interest Dividends

• These dividends may affect the amount of tax you pay on your social security income

If your income rises above certain levels, Social Security income is partially taxable. Having a large amount of exempt-interest dividends may increase your tax liability for the amount you pay on your Social Security income.

• Exempt-Interest Dividends may impact your deduction for investment interest expense and other investment expenses

Any expense that relates to exempt-interest dividends is not allowed to be deducted. This is applicable to any investment interest expense and any other types of investment expenses. To claim your deductions, you must limit them to the portion of investment expenses that do not relate to income earned from exempt-interest dividends.

The amount of deduction is the portion of your investment income that is taxable. For example, if you have $100 of investment interest expense or other investment expenses, and 50% of your investment income is taxable, then only $50 of the deduction would be allowed (other limitations apply to these types of deductions.)

But if your expenses relate to specific investments, you do not have to use this rule for those expenses. For example, if you subscribe to an investment research forum that has nothing to do with your exempt interest investments, you are not required to allocate part of that expense to your exempt interest income.

• Exempt-Interest Dividends may be subject to alternative minimum tax (AMT)

Form 1099-DIV indicates the amount of exempt interest you received from your mutual fund. If you only received a small amount of interest in this category, you need not worry about AMT. However, if you received large amounts of interest, or income that may be affected by AMT, these exempt-interest dividends may cause you to pay additional taxes.

To avoid this situation, you can research different types of mutual funds that invest in bonds that do not produce AMT interest.

• Exempt-Interest Dividends may be subject to State income tax

Exempt-interest dividends are free from federal income tax; however, they may not necessarily be exempt from state income tax. While some states do not offer exemptions for municipal or government bond interest, some provide these exemptions only if the bonds are issued by the state.

Do your due diligence to make sure your state allows you to receive exempt-interest dividends.

• Reinvesting your exempt-Interest dividends

If you plan to reinvest your dividends, realize that it will be treated as though you received the distribution (tax-free) in cash to use it to make a purchase of additional mutual funds. This will reduce the amount of interest you have gained or increase the amount of your losses at the time you sell your shares.

Final Thoughts

While exempt-interest dividends are a great way to lower your federal tax liabilities, it demands a thorough understanding of all its advantages and disadvantages before you invest.

Calculating your taxes on mutual fund distributions can be complex and if you are facing any difficulty in managing your investment income, it would be best to consult a tax professional to ensure you do not overpay your taxes.