When mutual funds distribute their income to shareholders, the distributions may fall into one of several categories and each is governed by a different set of tax rules.
Interest from state and local municipal bonds is generally free from federal income taxation. Mutual funds that invest in these bonds typically distribute this interest to shareholders in the form of an exempt-interest dividend. In some states, the interest may be exempt from state taxes in the state where the bonds are issued. A portion of this income may be subject to the alternative minimum tax.
Beginning in 2006, mutual funds are required to report tax-exempt interest to shareholders and to the Internal Revenue Service. In 2007, the funds will report this information or on IRS Form 1099-INT, Interest Income. RiverSource Investments will report this information on a supplemental statement.
A distribution from a mutual fund that does not come from the fund’s earnings is known as a return of capital distribution. These distributions often occur when a fund is liquidating and are sometimes incorrectly referred to as a “nontaxable dividend” or a "tax-free dividend."
If a fund pays out more in distributions that it earned during the year, you do not owe tax on your share of the excess amount, which is called " ‘nontaxable distribution" or "return of capital". This distribution reduces your basis in the shares. Your basis cannot be reduced below zero. If your basis is zero, the non-dividend distribution becomes a capital gain. Your tax advisor can help you if this occurs.