Tax on mutual funds dividends

Unless you invest your money in a tax-deferred retirement account (as explained later in this chapter), dividends you receive in the form of a distribution are generally treated as taxable income. Currently, the government taxes dividends at the ordinary federal income tax rate of 15% to 39.6%, depending on your overall taxable income. You generally have a choice (selected when you open your mutual fund account) of receiving dividend distributions in the form of a payment by check or reinvesting them in the purchase of additional shares of the fund. Don’t fall for the myth that if you reinvest the dividends you receive, the dividends are not taxable.
Unfortunately, that wishful thinking is not true. Although you never actually see the dividends in the form of cash, the dividends reinvested on your behalf during the year appear on your 1099-DIV form, and the IRS expects payment of all taxes due on these dividends.
If you want to avoid paying taxes on dividend income, you can opt to invest in a growth fund or a small cap fund. Such funds generally pay lower dividends than large cap funds or income funds, because they invest in small companies that use their profits to finance business expansion rather than paying dividends to investors. As a result, you’re likely to receive lower dividends while enjoying greater profits in the form of net asset value growth.
However, the positive tax effect of lower dividends may be spoiled if the fund’s rate of turnover is unusually high. If the fund manager buys and sells stocks frequently, the fund is likely to experience greater than average capital gains, on which the individual investor must also pay taxes. So, if you choose a fund partly to avoid heavy tax payments, make sure to check its turnover rate before investing. You can also delay or avoid some tax liabilities for dividend income by choosing a tax exempt municipal bond fund or by putting your mutual fund investments in a tax-deferred account, such as an IRA or 401(k).