Mutual funds generate three types of investment income: interest, dividends or capital gains. Any fund that is held in a retail account will be subject to tax on the returns it posts in the same manner as any other type of security. Mutual funds send their retail shareholders 1099 INT, DIV and B forms each year listing the amounts of each of these types of income that they received.

See also How to Read Your Annual Mutual Fund Report

Interest and dividends are both taxed as ordinary income which means that they are taxed at the investor’s top marginal tax bracket in the same manner as IRA or retirement plan distributions. Short-term capital gains (gains that have been held for a year to the day or less) are as well, while long-term capital gains are taxed at a lower rate. Mutual funds that have accumulated capital gains will usually post them once a year in November and all shareholders who own shares at that time will be presented with a tax bill commensurate with the number of shares that they own.

The price at which mutual fund shares are purchased is known as the cost basis. This price is subtracted from the sale price when shares are sold and the difference constitutes the taxable gain or deductible loss that is reported on the 1040.

There are five different ways that cost basis can be computed for securities: FIFO (First-In-First-Out), LIFO (Last-In-First-Out), Dollar value LIFO (same as LIFO except that purchases and sales are matched against each other by dollars instead of shares), average cost and specific ID. The right method to use for a given purchase will depend on the seller’s current financial circumstances and tax bracket. LIFO and Specific ID will often result in the lowest tax bill, but not always. Novice investors may have difficulty determining the best method for them and should probably enlist a tax or financial advisor to help them with this matter.

There is an important rule to remember if you own retail mutual funds that are reinvesting the dividends that they pay back into the purchase of additional fund shares. While the dividends will still be taxed as ordinary income as mentioned previously, they also need to be added to the cost basis of the shares when you sell them. Reinvesting dividends can therefore not only help your shares to multiply over time, but will reduce your tax bill as well.

Be sure to see the Cheapest Mutual Funds for Every Investment Objective

There are several key steps that you can take to reduce the tax bill you receive from your mutual funds each year. The first and most obvious step is simply to purchase and hold them inside a tax-deferred or tax-free account such as a traditional or Roth IRA or qualified retirement plan.

Your funds will grow faster in these plans over time, because the money that you would otherwise be paying away in taxes will instead stay in the account and continue to make you more money. However, you can only make cash contributions to these accounts and plans, so if you are just starting to purchase your shares, then open one of these accounts first and funnel your investment inside it.

If you want to move funds that you currently have in a retail account into them, then you will first need to sell them and declare a gain or loss and then make your contribution using the proceeds. You will then of course repurchase the fund inside the tax-deferred vehicle and can escape receiving 1099 forms on them from then until the time you begin taking distributions.

You can also purchase tax-efficient mutual funds outside your retirement plans that seek to minimize capital gains by reducing portfolio turnover. These are usually referred to as “tax-managed” funds, which usually don’t guarantee that you will have no capital gains or investment income, but may strive for that goal each year. As a general rule, it is wise to pick funds that have lower turnover anyway, as this usually means not only a lower tax bill but lower transaction costs that can drag down the fund’s return over time.

There is also another class of mutual fund known as “tax-exempt” funds that do guarantee that they will not produce taxable income during the year. Municipal bond funds are a prime example of this type of fund, although the shareholder may need to live in the state or locality where the fund is issued.

For example, a fund that invests solely in municipal bonds issued by the state of Arkansas will only be able to provide tax-free interest to residents of that state who have incomes below the AMT threshold. High-income investors may be subject to the AMT, or Alternative Minimum Tax if they receive certain types of income, such as municipal bond income that exceeds an AGI limit for that year.

Be sure to check out the 30 Blogs that Mutual Fund Investors Should Read

There are several issues to consider when you purchase mutual funds. Be sure that you understand first what type of investment returns you can expect to receive from your funds, whether it will be dividends, interest, capital gains or some combination thereof. If you understand how each of these types of income is taxed, then you won’t be surprised when you receive your end-of-year tax forms at the end of January. For more information on the taxation of mutual funds, visit the IRS website at www.irs.gov and download the instructions for Forms 1099-DIV, 1099-INT and 1099-B or consult your tax or investment advisor.