With a working knowledge of how mutual funds are taxed along with some diligent bookkeeping, you can reduce the amount your mutual investments are taxed on. The below gives you the understanding you need of mutual fund taxation.

Income is usually reported on any mutual fund distributions, regardless if they are or if they are not reinvested. Tax law typically sees mutual fund shareholders as direct owners of a portion of the fund's portfolio of securities. Ergo, dividends, interest and capital gains from the sales of securities, are counted as taxable income of the shareholder.

The 2 types of taxable distributions, dividends and capital gains:
1. Ordinary Dividends: When you earn dividends and interest on a mutual fund, these are considered taxable income since these are paid out to shareholders at fixed intervals. Similar to returns on other investments, the payments from mutual funds dividend decrease or increase each year according to the earned income of the fund in regards to the fund’s investment policy. These payments resulting from dividends are defined as ordinary income and you’ll need to report it as so on your tax return.

 Qualified dividends: Like capital gains, qualified dividends are ordinary dividends that are taxed the same zero or fifteen percent maximum rate which applies to capital gains. The gains are taxed at the fifteen percent rate and if the regular rates that apply is twenty-five percent or higher. Thirty-nine percent is the highest tax bracket and it is taxed at a twenty percent rate. Should the regular rate be applied and is below twenty-five percent, then the qualified dividends are taxed at the zero percent rate. Dividends awarded from corporations that are foreign become qualified when their shares or ADRs are traded in U.S. exchanges or when the dividends are umbrellaed by U.S. tax treaties. Mutual funds’ dividends qualify where the fund results in qualified dividends and then those dividends are proportionately distributed.
2. Capital gain distributions: When a fund being sold makes more than it loses, the gains are allocated amongst the investors. Like ordinary dividends, capital gain allocations increase or decrease each year. The dividends are viewed as long-term capital gain no matter how long you’ve owned your shares of the fund.

An owner of mutual funds can also have capital gains from the sale of mutual fund shares.

Tax Rates on Capital Gains
The rates resulting from the sale of mutual fund shares apply to profits generated on shares you’ve had more than a year. However, the profit from shares held a year or less before selling is considered ordinary income—nonetheless, capital gain allocations are considered long-term no matter the duration of time the shares were held being allocated.

Consider if your taxable income (excluding long-term gains and qualified dividends) has you in a tax bracket below twenty-five percent (that's under $74,900 for a married filing jointly return in 2015). In this scenario, you'll benefit from the lower rate which is zero percent for qualified dividends and long-term gains on the sum of the gain that’s in between your taxable income and the beginning of your twenty-five percent bracket.

It’s important to note the qualified 5-year capital gains on stock where specific rules imposed on the gains of selling capital assets possessed longer than 5 years became expired as of 12/31/2012—this was permanently repealed as the result of the American Taxpayer Relief Act (also known as ATRA) of 2012.

Reporting Mutual Fund Income
Your mutual fund facilitator is required to send you a 1099-DIV prior to doing your taxes. The 1099-DIV is a record of what you earned and what you need to report on your tax return as well as how much of it constitutes qualified dividends. Since tax rates for qualified dividends are equal to the capital gains distributions and long-term gains of sales, these items should be combined when reporting reporting so that qualified dividends are added to long-term capital gains. Furthermore, capital losses are subtracted from capital gains prior to being applied to the favorable capital gains rates. However, losses will not be subtracted from dividends.

Non-Allocated Capital Gains
In some cases, a mutual fund may retain a portion of its capital gain and pays taxes on them. You’re required to report your share of these type of gains and you’ll be eligible for a credit on the tax paid. The mutual fund facilitator will report these amounts to you on Form 2439. The cost basis of your shares increase up to sixty-five percent of the gain—thus, representing the gain decreased by the credit.

Medicare Tax
Beginning in 2013, an additional 3.8 percent Medicare tax is applicable to net investment income for filers with modified adjusted gross income (AGI) above $200,000 (single filers) and $250,000 (joint filers).