In addition to costs and risks, taxes are always an important consideration in evaluating an investment. How you're taxed depends on the type of mutual fund in which you're invested.
You will owe income taxes on the distributions from your equity fund unless your shares are held in a tax-deferred or tax-free account. In the case of capital gains distributions, earnings are taxed based on how long the fund has owned the shares, not how long you've owned shares in the fund. Distributions on assets owned by the fund for less than one year will be figured at a short-term capital gains rate, while earnings on assets held longer than one year will be taxed at a long-term capital gains rate.
Equity fund income distributions are generally taxable at the lower long-term capital gains rate that applies to dividends paid by most U.S. corporations. Your annual 1099 statement from the fund will provide the information you need to determine the correct rate.
Bond Fund Taxation
Bond fund income distributions may be taxable or tax-free. Municipal bond fund income is exempt from federal tax and also state and local tax if you live in the municipality in which the underlying bonds are issued. Tax-free bond funds pass along interest earned at slightly lower rates than taxable funds collect, but may sometimes be attractive to investors in higher tax brackets because they have the potential to result in higher actual earnings. Income distributions on Treasury, corporate and most agency bond funds are taxable at the same rate as your regular income.
Capital gains realized on all types of bonds funds are, however, taxed at the regular rate if they are short-term gains or at your reduced rate if they are long-term gains.
Income distributions from money market funds can be taxable or tax-free. Taxable funds buy what they believe are the best-yielding short-term corporate or government issues available and pay slightly higher interest rates than tax-free funds. These funds are taxable at federal and sometimes state and local levels. Tax-free funds buy primarily municipal debt and many are established for high-tax states like New York or California.
Distributions are taxed whether they are reinvested or paid out in cash, unless the fund loses more than it makes in any year. In that case, future distributions aren't taxed until profits equal accumulated losses.
Investors should consider the investment objectives, risk, charges and expenses of a mutual fund carefully before investing. A mutual fund's prospectus contains this and other information about the mutual fund and is available through www.scottrade.com or through a Scottrade branch office. The prospectus should be read carefully before investing.