Some funds pay ongoing dividends to shareholders. These dividends represent:
Income-based funds are the most likely to pay ongoing dividends. Growth funds tend to pay little, if any, because many growth companies reinvest earnings instead of paying dividends.
Here are two real-world examples:
Franklin DynaTech Fund (Ticker: FKDNX)
*Although this fund has not paid a dividend since 2001, it typically makes a capital gain distribution annually to shareholders. We will discuss capital gain distributions below.
Franklin High Yield Fund (Ticker: FVHIX)
Bottom line: a fund must receive income before it can distribute dividends to shareholders. That income typically comes from dividend-paying common stocks, preferred stocks, and debt securities. If a growth fund invests in companies that don’t pay dividends, the fund generally won’t pay dividends either - there’s no income to pass through.
The tax rate paid on dividends is determined by an investor’s annual taxable income, which includes all of the following:
In general, the more taxable income an investor has, the higher their tax rate. Dividends can be qualified or non-qualified, which affects how they’re taxed. Qualified dividends are taxed at lower rates than non-qualified dividends (discussed below). Here’s the basic breakdown:
Qualified dividend tax rates
Test questions relating to tax brackets tend to be generalized because these brackets change annually. Still, here’s a table with the specifics for investors filing single and married filing jointly (for the tax year 2025):
| Tax Rate | Individuals | Married filing jointly |
|---|---|---|
| 0% | $0 - $48,350 | $0 - $96,700 |
| 15% | $48,350 - $533,400 | $96,700 - $600,050 |
| 20% | $533,400+ | $600,050+ |
Do not memorize the specifics; this chart is only for context.
For a cash dividend to be qualified, it must meet two general requirements imposed by the IRS:
*To be considered a qualified foreign corporation, it must meet any one of the following requirements:
**Unhedged means unprotected. An unhedged position does not have any insurance or another related product that would prevent the investor from a loss.
***The holding periods established by the IRS are bizarre and unlikely to be tested (knowing a holding period requirement exists for a dividend to be qualified should suffice). For example, the holding period for common stock dividends requires the stock to be held for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date.
In a mutual fund, these requirements are evaluated based on the fund’s underlying holdings. For example, assume we’re looking at a value fund that holds only common stock. For a dividend paid by the fund to be qualified:
If those conditions are met, the dividend passed through to the fund’s shareholders is treated as a qualified dividend.
If a dividend is not qualified, it’s taxed as a non-qualified (ordinary) dividend. The tax rate equals the investor’s federal marginal income tax bracket. As of the tax year 2025, these are the income tax brackets for individuals and those filing jointly:
| Rate | Individuals | Married filing jointly |
|---|---|---|
| 10% | $0 | $0 |
| 12% | $11,926 | $23,851 |
| 22% | $48,476 | $96,951 |
| 24% | $103,351 | $206,701 |
| 32% | $197,301 | $394,601 |
| 35% | $250,526 | $501,051 |
| 37% | $626,351 | $751,601 |
Do not memorize these tax brackets; this chart is only for context.
The federal income tax rate an investor falls into determines the tax rate they pay on non-qualified dividends. Qualified dividends are taxed at the lower qualified-dividend rates. For example, assume an individual with $50,000 of annual income receives a $100 dividend:
Dividends paid out of certain funds are always considered non-qualified. For example, dividends paid out of mutual funds holding US government and/or corporate debt securities. If an investor held these bonds directly, the interest would be taxed at a rate equal to their federal income tax bracket. The IRS treats the “pass-through” of this interest via a non-qualified mutual fund dividend* in a similar way.
*Income paid out of a mutual fund is always considered a dividend, regardless of the source income. For example, assume a bond fund receives interest from the bonds in its portfolio. When the interest is “passed through” to the fund’s shareholders, we call it a dividend.
Some dividend payments can be entirely tax-free (regardless of tax bracket). In particular, a municipal bond fund invests in debt securities that pay federally tax-free income. In some cases, the income may also be free from state and local tax if the investor is a resident of the issuing state or municipality. For example, an investor residing in California would receive tax-free dividends from the Putnam California Tax Exempt Income Fund* (Ticker: PCIYX).
*This fund invests primarily in California municipal bonds, which pay tax-exempt income to investors residing in California.
Capital gains occur when a security’s sales proceeds exceed its cost basis. When an investor purchases a security, the overall cost is reported to the Internal Revenue Service (IRS) as the “basis.”
Let’s assume an investor purchases shares of ABC Fund at a public offering price* (POP) of $50. Their reported cost basis would be $50 per share.
*Cost basis includes any transaction fees. Therefore a fund with a NAV of $49 and a sales charge of $1 would result in both a $50 POP and $50 cost basis. The same goes for stocks, bonds, or any other security. For example, a stock purchased for $75 with a $1 commission would result in a $76 cost basis.
Now assume the investor holds the ABC Fund shares for a while, then redeems the shares at $61 with a $1 redemption fee. The investor would report $60 in sales proceeds.
Similar to cost basis, sales proceeds factor in transaction costs. The key difference is:
Let’s summarize what just occurred:
Cost basis = $50
Sales proceeds = $60
Total capital gain = $10
The $10 capital gain was realized when the security was sold. If the shares had not been sold, the investor would have an unrealized capital gain (a gain “on paper”). The IRS taxes gains when they’re realized.
At the end of each year, investors net their capital gains and losses to determine whether they owe taxes. Let’s work through an example:
January 30th
March 15th
July 10th
If these three transactions were the only trades placed during the year, the investor ends up with a $4,000 net capital gain (gains are netted against losses). The investor must pay tax on the net gain. The tax rate depends on whether the gains are long-term or short-term.
Long-term capital gains are made on securities held for longer than a year. An investor must hold an investment for one year and a day for the gain to be long-term. Long-term capital gains are taxed similarly to qualified dividends - at a rate of 0%, 15%, or 20% (review above for the details).
Short-term capital gains are made on securities held for one year or less. Short-term capital gains are taxed at the investor’s income tax bracket, which could be as high as 37% (similar to non-qualified dividends).
What happens if there’s a net capital loss for the year? Let’s use the same figures, but change the July 10th trade.
January 30th
March 15th
July 10th
The investor now ends with a $13,000 net capital loss. Losing money on an investment is never fun, but capital losses can reduce taxes paid by investors.
If an investor has a net capital loss for the year, they can deduct up to $3,000 of the capital loss against earned income that year. Assuming this investor made $100,000 from their job, they could deduct $3,000 to bring their taxable income to $97,000. That deduction reduces their tax obligation.
In this example, $10,000 of the $13,000 net capital loss is left over. Any leftover portion “rolls over” to the following year, which can reduce taxes on future gains. For example, the investor could realize $10,000 of capital gains next year and owe no tax on those gains (because the rolled-over $10,000 capital loss offsets them).
A fund investor can receive capital gains in two ways:
Fund managers invest shareholder money and may trade securities inside the fund’s portfolio. When a fund manager sells a security for a profit, the fund realizes a capital gain.
Capital gains realized inside the portfolio are often “passed through” to shareholders (we’ll learn why later in this chapter). If that happens, the investor receives a distribution even though they didn’t sell their own fund shares. The investor may also owe tax on that distribution.
The tax status of the distribution (long-term or short-term) depends on how long the fund held the security before selling it. While funds can distribute short-term capital gains on any schedule, long-term capital gains may only be distributed once per calendar year.
Subchapter M, also referred to as the “conduit rule,” allows funds to avoid taxation. This IRS rule requires funds to distribute at least 90% of their net investment income to shareholders to qualify. In reality, most funds distribute upwards of 98-99% of their investment income to shareholders by the end of the year. Funds that engage in Subchapter M are called regulated funds.
By meeting this requirement, the fund shifts taxation to shareholders, who may owe taxes on the income they receive. This structure helps prevent the fund itself from paying substantial taxes out of its assets. If a fund had to pay large taxes at the fund level, the fund’s NAV would decline because taxes would be paid from the portfolio.
Many investors will pay lower or no taxes on the income received. First, many investors are in lower tax brackets than large funds. Additionally, some investors own mutual funds in tax-sheltered retirement accounts. We’ll learn more about this in the retirement plans chapter. For now, assume investors do not pay taxes on returns in retirement accounts.
Dividends are reported annually on tax form 1099-DIV. Brokerage firms send these forms to their customers and to the IRS. The form details dividends received and their status (qualified or non-qualified). For a dividend to appear on a given year’s 1099-DIV, it must be paid in that year. If a dividend were declared in 2025 but paid in 2026, it would be reported on the 2026 1099-DIV.
Similarly, interest received from debt securities is reported on tax form 1099-INT. Interest is reported on a given year’s tax forms only if it was received in that calendar year.
Capital gains are reported on form 1099-B (B stands for brokerage proceeds). Every year, brokerage firms report their customers’ capital gains and losses. If the investor has more gains than losses (a net capital gain), they will owe taxes. As discussed above, a net capital loss can be used as a deduction.
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