Investing Assets & Markets Mutual Funds How To Avoid the Double Taxation of Mutual Funds By Kent Thune Updated on December 22, 2022 Reviewed by Gordon Scott Fact checked by Ariana Chávez Sponsored by What's this? & In This Article View All In This Article How Mutual Funds Are Taxed How Investors Mistakenly Double Pay Mutual Fund Taxes How To Avoid Paying Twice Frequently Asked Questions (FAQs) Photo: Kateryna Onyshchuk / Getty Images Simplicity is among the greatest advantages of mutual funds, with the exception of taxation. But you can fully enjoy the advantages and worry yourself less about the complexities if you know some of the tax rules and tactical tricks of investing in mutual funds. Key Takeaways Mutual funds are one of the simplest, most reliable investment choices, but they can get complicated with taxes.Mutual fund investors will owe taxes on any dividends or capital gains earned by the fund while they own it.You can even owe long-term capital gains taxes after owning shares briefly, because it's the fund's activity, not yours, that determines this.Many investors also mistakenly pay double taxes on dividends that they reinvest in the mutual fund. How Mutual Funds Are Taxed Mutual funds are not the same as other investment securities, such as stocks, because they're single portfolios. They're called pooled investments, and they hold dozens or hundreds of other securities. The taxable activity that takes place as part of mutual fund management passes along tax liability to you, the mutual fund investor. You'll owe tax on two levels if a stock holding in your mutual fund pays dividends, then the fund manager later sells the stock at a higher value than they paid for it: A dividend tax, which is generally applied at your income tax rateA capital gains tax, which will be taxed at capital gains rates It's possible that you could receive a long-term capital gain distribution (assuming the mutual fund held the stock for more than a year) even if you've only held the mutual fund for a few months and you haven't sold any shares. Note The taxes distributed to you are due to the activities within the mutual fund, not due to your own investing activities. How Investors Mistakenly Double Pay Mutual Fund Taxes Let's assume five years have passed and you sell your mutual fund. Your original investment was $10,000 worth of shares in the fund and it had paid $400 in dividends per year for five years. You're a prudent, long-term investor, so you elected to have all dividends reinvested in more shares of your mutual fund. You did a pretty good job selecting your mutual fund, and its share price appreciation, including dividend reinvestment, gives you a final value of $15,000 when you sell. You bought the fund at $10,000 and you sold it at $15,000, so you'll pay tax on $5,000 in capital gains, right? Yes, if you're like millions of other investors who make the same mistake. You would pay tax on the $5,000 in "gains," but that would be too much. Remember, your original investment was $10,000 but you also invested (or rather re-invested) $2,000 in dividends. Therefore your basis is $12,000 and your taxable gain is $3,000, not $5,000. How To Avoid Paying Twice The example here is simplified and it doesn't account for compounding interest, but the lesson remains the same: Most investors think the amount they invested into the mutual fund out of their own pocket is their original investment amount or "basis" for tax reporting. But the Internal Revenue Service (IRS) says all reinvested dividend and capital gain distributions count as “investments,” too. You can avoid making the same mistake by simply keeping all your mutual fund statements and paying attention to all amounts invested. More importantly, pay attention to the amounts "reinvested." You can also refer to IRS Publication 550. Even better, keep your statements and pass them along to your tax professional while you go about your life. Frequently Asked Questions (FAQs) What's the difference between long-term and short-term capital gains? A gain is short term if you hold an asset, such as a mutual fund, for one year or less. It's long term if you hold it for more than a year. Short-term gains are taxed as ordinary income according to your tax bracket. Long-term gains are taxed at no more than 20%, but most people pay no more than 15%. Can I offset gains with my losses? Capital losses can offset your gains to an extent. You can claim losses up to $3,000 (or $1,500 if you're married and file a separate return) or your total net loss, whichever is less. The information on this site is provided for discussion purposes only, and should not be misconstrued as tax advice or investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Was this page helpful? Thanks for your feedback! Tell us why! Other Submit Sources The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy. IRS. "Why do I Have to Report Capital Gains From My Mutual Funds if I Never Sold Any Shares of That Mutual Fund?" IRS. "How are Reinvested Dividends Reported On My Tax Return?" IRS. "Topic No. 409 Capital Gains and Losses."