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TAXES
JULY 15, 2020

Do I have to pay taxes on mutual fund earnings?

Answered by
Nick Giorgi
Investment Strategist, Chief Investment Office, Merrill and Bank of America Private Bank
Generally, yes, taxes must be paid on mutual fund earnings, also referred to as gains. Whenever you profit from the sale or exchange of mutual fund shares in a taxable investment account, you may be subject to capital gains tax on the transaction. You also may owe taxes if your mutual fund pays dividends. The amount of tax owed ultimately depends on the combined total of your gains and losses.
Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.
"Realizing a capital gain from one mutual fund doesn't guarantee that you'll owe taxes on that gain. Each dollar of capital loss potentially can offset a dollar of capital gain."
— Nick Giorgi, Investment Strategist in the Chief Investment Office, Merrill and Bank of America Private Bank

A closer look at the capital gains tax

Short-term capital gains are gains from the sale of capital assets held for 12 months or less and are taxed at ordinary income tax rates. Long-term capital gains are gains from the sale of capital assets held for more than 12 months and are currently subject to a federal long-term capital gains tax rate of up to 20%.
2020 Capital Gains Tax RatesFootnote 1
Short-term
Held for 12 months or less
Ordinary income tax rate
Long-term
Held for more than 12 months
0%, 15% or 20% depending on your taxable income
But a capital gain in one mutual fund doesn't guarantee that you'll owe taxes on that gain. Each dollar of capital loss potentially can offset a dollar of capital gain.
For example if, in the same tax year, you have $1,000 in long-term capital gains and $600 in long-term capital losses, you'll pay tax only on the net long-term capital gain of $400. If your capital losses exceed your capital gains for the tax year, you can use up to $3,000 of these excess capital losses to offset ordinary income in such tax year. You can carry over excess capital losses of more than $3,000 to offset capital gains in future tax years (and, potentially, ordinary income of up to $3,000 per year).
At the same time, you can owe capital gains taxes every year on mutual funds even if you don't sell them. That's because when mutual fund managers sell stocks in a fund (referred to as the fund's underlying assets) and realize a gain, they have to distribute most of that gain to shareholders. Sometimes this is called a capital gains dividend, and can result in receiving an unexpected tax bill at the end of the year.

A quick review of how dividends are taxed

Qualified dividends, which are dividends that meet several statutory conditions, are generally taxed at preferential, long-term capital gains rates, up to a maximum of 20% for high-income investors. Dividends that don't meet the qualified dividend conditions are generally taxed at ordinary income rates.
Taxes are one of many things to consider when it comes to investing in mutual funds. Check out our guide to understanding mutual funds if you're interested in exploring this investment choice further.
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Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.
Footnote 1 You also may be subject to a 3.8% net investment income tax.

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