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.
When a mutual fund receives dividends from domestic and qualifying foreign corporations within its portfolio, it generally may pass them along to investors as a qualified dividend distribution.
The federal tax rates that apply to long-term capital gains also apply to qualified dividends, which include dividends paid by domestic and qualifying foreign companies. For a dividend paid by a mutual fund to qualify for the special dividend tax rate, investors are required to hold their fund shares for more than 60 days in the 121-day period beginning 60 days before the ex-dividend date.
If investors do not hold their shares for the required period, the dividend will be taxed as ordinary income. Just as qualified dividends currently are subject to the same tax rates as long-term capital gains, they are also subject to the same changes from 2008 to 2010 as well as the same “sunset” or expiration rule in 2011, unless Congress amends existing rules.
| Ordinary Income Tax Rate |
Rates on Qualified Dividends 2006-2007 |
Rates from 2008-2010 |
| 10% | 5% | 0% |
| 15% | 5% | 0% |
| 25% | 15% | 15% |
| 28% | 15% | 15% |
| 33% | 15% | 15% |
| 35% | 15% | 15% |
1. Unless Congress acts before then.