Tax Issues for Mutual Fund Investors

Mutual funds are required to pay distributions of all their income and realized gains each year. Distributions are taxable whether you take them in cash or reinvest them. There are two exceptions: 1) Income dividends from municipal bond funds are usually exempt from federal taxation, and all or a portion may be exempt from state and local taxation, depending on what portion of the fund’s assets were invested in a particular state; 2) Income dividends and net capital gains distributed to IRA and other retirement accounts are tax-sheltered until withdrawn.

Keep in mind that you should add reinvested income dividends and capital gain distributions (from both taxable and tax-free funds) to your original cost basis when it comes time to figure gains or losses on shares sold.

Distributions are taxable for the year in which they are paid. However, the tax law states that mutual fund dividend or capital gain distributions declared within the last three months of the year but paid the following January are taxable as though they were paid on December 31. Therefore, such distributions are included on IRS Form 1099-DIV mailed to you in late January.

In late January, the fund will send Form 1099-DIV to you and the IRS. Box 1a reports a combined total for dividend income and short-term capital gains (since short-term gains are taxed at ordinary income tax rates). Box 1b reports the portion of Box 1a that is qualified dividends. Qualified dividends are eligible for taxation at a maximum rate of 15% (0% for investors in the 15% or 10% tax bracket in 2008 through 2010) if you held your shares for at least 61 days during the 121-day period beginning 60 days before the ex-dividend date of the distribution. Box 2a reports net long-term capital gains.

Please note that little, if any, of the dividends paid by T. Rowe Price money market funds, bond funds, and the Real Estate Fund, are expected to qualify. In addition, all or a portion of a fund's dividends may not qualify for the lower tax rate if its income is derived from interest, short-term gains, or other nonqualified sources.

1. Mutual fund distributions. Mutual funds distribute their annual realized net capital gains to shareholders on a pro-rata basis. The fund notifies the shareholder whether the gains are long term or short term. (Remember that short-term gains are treated as ordinary income.)
   
   The status of any capital gain distributed to you by a mutual fund depends on how long the fund owned the securities that produced the gain—not on how long you owned shares in the fund.
2. Shareholder transactions. Shareholders can also generate capital gains by selling or exchanging shares in mutual funds (except money funds, which are managed to maintain a stable share price).

The rate that applies to your sale of shares depends on how long you held the shares. Short-term capital gains for securities held one year or less are taxed at ordinary income rates, which could be as high as 35% at the federal level. Long-term gains (on securities held more than one year) are taxed at 15% (or 0% for investors in the 15% or 10% tax bracket in 2008 through 2010).

1. Shareholder transactions. Investors can use their capital losses from fund transactions to offset capital gains from other sources. Any net capital losses can be used to offset ordinary income dollar for dollar up to $3,000 (or $1,500 if married but filing separately) in any one year. Unused losses can be carried forward indefinitely. (See IRS Publication No. 564.)
2. Mutual fund transactions. The fund's capital losses are never distributed to shareholders but are used to offset capital gains realized by the fund during the year. Any additional losses are carried forward by the fund for up to eight years to apply against gains realized in the future. The only losses you can claim are those you may have incurred when you redeemed your own shares of a fund.

Unless you are conducting transactions in a tax-sheltered retirement plan, an exchange of assets from one fund to another is the same as a sale and purchase for tax purposes. In January, each mutual fund reports proceeds of sales (redemptions or exchanges) made during the year to the IRS and to you on Form 1099-B. The 1099-B does not need to be attached to your Form 1040, but the data on it should match what you report Form 1040, Schedule D.

Some fund companies (including T. Rowe Price) furnish to you your cost basis and your capital gain or loss for shares redeemed during the year. This information is not reported to the IRS, and you are not obligated to use it. Many fund companies use the average cost method, which calculates your average cost per share by dividing total dollars invested by the total number of shares held. If your fund does not calculate your gain or loss, you must rely on your own records for this calculation.

You could use one of two other methods to calculate your gains and losses. With the specific identification method, you specify which shares have been sold, identifying them by the purchase date. With the First In, First Out (FIFO) method, you are deemed to sell the shares held the longest first. But no matter which of these methods you use, you will need to keep a record of all your past purchases so you can accurately identify the cost basis. (For further information, consult your tax adviser or request IRS Publication No. 564.)

Note: If you realize a capital loss on mutual fund shares held less than six months and you received a long-term capital gain distribution from the fund while you held those shares, only the portion of your loss that exceeds the amount of the distribution can be reported as a short-term loss. The portion that is equal to or less than the distribution is long term.

“Wash sale” rules apply to mutual funds. If you sell shares at a loss, you can’t claim the loss if you purchased other shares in the same fund within 30 days before or after the sale.

1. The income you receive from a municipal bond fund is exempt from federal income taxes, and income earned on bonds issued by the state or locality in which you reside or pay taxes is generally exempt from taxation in that state. (Income from certain "private activity" bonds may be subject to the alternative minimum tax; see subsequent discussion of the AMT.)
2. Capital gains distributed by the fund or resulting from your own sales of shares in a tax-free fund are subject to federal and most state capital gains taxes. Some states do not tax gains earned on their own securities. (Consult your local taxing authority.)

Note: If you received tax-exempt dividends on shares that you held for six months or less and sold at a loss, you may claim only the portion of the loss that exceeds the amount of the dividends. (See IRS Publication No. 564.)

The AMT may apply to those who have substantial tax deductions or derive substantial income from so-called "tax preference items"—incentive stock options, certain private activity municipal bonds, and other types of tax-sheltered investments. Income from these items generally must compose a significant percentage of the taxpayer’s total income from all sources before triggering AMT liability. As regular tax rates have been lowered, the AMT is affecting more middle-income, as well as higher-income, taxpayers.

At year-end, your fund should notify you of the percentage of fund dividends, if any, that was derived from tax preference items for AMT purposes. (This information is not reported to the IRS.) You may wish to consult a tax adviser or Instructions for IRS Form 6251 to determine if you are subject to this tax.

1. You do not receive a Form 1099-DIV unless the fund made a capital gain distribution during the year, because income dividends from tax-free funds are exempt from federal taxation. Any distributions of short-term capital gains are reported as "ordinary income" on Form 1099-DIV.
2. Exempt-interest dividends paid by a mutual fund are reported to the IRS. This amount is shown in box 8 of your Form 1099-INT. You must report this (on Form 1040, line 8b) along with any other tax-exempt interest you may have received during the year. (This information is used to determine the tax status of any Social Security payments you may have received.)

If a tax-free bond fund buys a municipal bond at a discount (price below par) and sells it for profit, a portion of that capital gain may be taxed at the investor’s ordinary income tax rate (provided the discount is sufficiently large) and the gain cannot be offset by any capital losses.

At year-end, your fund should provide information regarding the percentage breakdown of your fund’s earnings by state. Most states tax income earned on out-of-state municipal bonds; consult your state’s taxing authority regarding tax treatment of municipal bond income.

When a fund with a certain amount of foreign investments must pay income taxes to foreign governments, the nonrefundable portion paid on your behalf is reported in Box 6 of your 1099-DIV and is also included in Box 1. When you file your U.S. tax return, you may use this amount either as a direct credit against taxes due (usually the more advantageous approach) or as an itemized deduction. You can only take the credit if you held the fund shares for 16 days during the 31-day period beginning 15 days before the fund’s ex-dividend date. The amount of the credit actually available to you may be limited depending on your particular tax situation.

Shareholders with $600 or less of foreign taxes ($300 or less if individual) can take advantage of a simplified method for taking the foreign tax credit.

States do not tax income earned on direct U.S. government obligations. However, if the income was derived from a mutual fund, some states require that a minimum percentage of the fund’s assets—usually 50%—be invested in these securities to qualify for the exemption.

In January, your mutual fund should notify you of the percentage of the fund’s income distributions earned from U.S. government securities and which funds had more than 50% of their total assets invested in such issues. Consult your state’s taxing authority regarding the law in your state.

When a fund pays out more income than it earned during the course of a year on a tax basis, the excess is called a “return of capital” and is reported on Form 1099-DIV as a nontaxable distribution. You should subtract any such amounts from the cost basis of your shares.

For example, if, at year-end, foreign currency trading losses are found to have offset income already paid out in an international bond fund, the excess income distributions would be reclassified as a nontaxable return of capital.

Mutual funds generally are required to withhold U.S. taxes on income dividends (but not on long-term capital gain distributions). Total dividends and the amount of taxes withheld are reported on Form 1042-S, which is mailed to you and the IRS in mid-March.

You may wish to call the Internal Revenue Service at 1-800-TAX-1040. To receive federal tax forms, call 1-800-TAX-FORM (829-3676) or visit the IRS Web site.

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