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I've been studying the prospectus for a Vanguard Index fund that I'm invested in, and I'm confused as to what percentage and what taxes I will end up paying. When the prospectus's tax information says that it will be taxable as ordinary income or capital gain, does that mean that I'll get hit with my top tax bracket rate as well as the capital gains tax (15%) when I realize any gains?

Additional related questions-

  1. What taxes will I be paying if I sell before 18 months (this number comes from a previous question that I asked and was told to hold the investment for at least 18 months to reduce the taxes)?
  2. How can I find if there is any local state tax on my investment when I sell? Would the regular sales tax apply here? I'm located in Texas.

Here is the Tax Information from the Prospectus

The Fund’s distributions may be taxable as ordinary income or capital gain. Distributions are taxable to you for federal income tax purposes, whether or not you reinvest these amounts in additional Fund shares. A sale or exchange of Fund shares is a taxable event, which means that you may have a capital gain to report as income, or a capital loss to report as a deduction, when you complete your federal income tax return. Dividend and capital gains distributions that you receive, as well as your gains or losses from any sale or exchange of Fund shares, may also be subject to state and local income taxes.

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  • Regardless of which state you live in, the sale of a stock or mutual fund will not trigger a sales tax, only income taxes.
    – mhoran_psprep
    Commented Feb 23, 2012 at 15:30

2 Answers 2

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At the end of each calendar year the mutual fund company will send you a 1099 form. It will tell you and the IRS what your account earned. You will see boxes for:

  • Dividends - these are payments that a company payed to all stockholders
  • Capital Gains - These could be long term or short term. These were triggered because the mutual fund sold shares of the stock.

You will end up paying taxes on these, unless the fund is part of a 401K or IRA. These taxes will be due even if you never sold any shares. They are due even if it was a bad year and the value of your account went down.

Most if not all states will levy an income tax yon your dividends and capital gains each year.

When you sell your shares you may also owe income taxes if you made a profit. The actual taxes due is a more complex calculation due to long term vs short term, and what other gains or losses you have. Partial sales also take into account which shares are sold.

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A mutual fund could make two different kinds of distributions to you:

  • Capital gains: When the fund liquidates positions that it holds, it may realize a gain if it sells the assets for a greater price than the fund purchased them for. As an example, for an index fund, assets may get liquidated if the underlying index changes in composition, thus requiring the manager to sell some stocks and purchase others. Mutual funds are required to distribute most of their income that they generate in this way back to its shareholders; many often do this near the end of the calendar year.

    When you receive the distribution, the gains will be categorized as either short-term (the asset was held for less than one year) or long-term (vice versa). Based upon the holding period, the gain is taxed differently. Currently in the United States, long-term capital gains are only taxed at 15%, regardless of your income tax bracket (you only pay the capital gains tax, not the income tax). Short-term capital gains are treated as ordinary income, so you will pay your (probably higher) tax rate on any cash that you are given by your mutual fund.

    You may also be subject to capital gains taxes when you decide to sell your holdings in the fund. Any profit that you made based on the difference between your purchase and sale price is treated as a capital gain. Based upon the period of time that you held the mutual fund shares, it is categorized as a short- or long-term gain and is taxed accordingly in the tax year that you sell the shares.

  • Dividends: Many companies pay dividends to their stockholders as a way of returning a portion of their profits to their collective owners. When you invest in a mutual fund that owns dividend-paying stocks, the fund is the "owner" that receives the dividend payments. As with capital gains, mutual funds will redistribute these dividends to you periodically, often quarterly or annually. The main difference with dividends is that they are always taxed as ordinary income, no matter how long you (or the fund) have held the asset.

I'm not aware of Texas state tax laws, so I can't comment on your other question.

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    As a minor addition, dividends in the US are of two kinds. Ordinary Dividends are taxed as ordinary income while Qualified Dividends receive special treatment. The mutual fund will tell you that it paid $x in dividends of which $y are Qualified Dividends, and you enter these amount as appropriate on your income tax return and compute taxes appropriately, typically paying at a lower rate on the $y$ of Qualified Dividends than on the $x-y of Ordinary Dividends. Money-market fund dividends are always Ordinary Dividends; stock market fund dividends are a mixed bag.
    – Dilip Sarwate
    Commented Feb 23, 2012 at 15:33

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