Distributions from a mutual fund are earnings from the fund's operation. Unlike individual company who can chose either to retain the profit, or return it to shareholders in the form of dividend or through share buyback, a mutual fund is required by law to be passed on profits to investors.
A mutual fund may incur three kinds of distributions: qualified dividends, capital gain, and ordinary income.
According to the IRS definition, qualified dividends are:
The ordinary dividends received in tax years beginning after 2002 that are subject to the same 5% or 15% maximum tax rate that applies to net capital gain.
For the dividend to be considered as qualified dividend rather than ordinary dividend, therefore subject to the favorable tax rate, the dividends must be paid by a U.S. corporation or a qualified foreign corporation and the mutual fund that holds the dividend-paying stock must have held the equity for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date (the first date following the declaration of a dividend on which the buyer of a stock will not receive the next dividend payment. Instead, the seller will get the dividend). Otherwise, the dividend will be taxed at the ordinary income tax rate.
For a mutual fund, capital gain is the profit made from selling a security in its holdings. This is the same profit we made when we sold a stock at the price higher than the price we paid for. If the fund (yes, it's the fund, not the fund investor) has hold the security for more than one year, the profit is treated as long-term capital gain, which is subject to a maximum of 15% tax rate for mutual fund shareholders who are at the 25% or higher tax bracket, or 5% for those whose tax rate is below 25%. On the other hand, if a stock is held in a fund for less than a year, the profit realized by selling the stock will be treated as short-term capital gain and taxed at the fund investor's ordinary income tax rate.
Ordinary income is the income other than capital gains. For a mutual fund, ordinary income is interest payment the fund received and distributed to investors as ordinary dividends. Ordinary income, as well as dividends that do not qualify for the qualified dividend definition, are taxed as the investor's ordinary income tax rate.
Distributions and mutual fund buying strategy:
When it comes to buying mutual funds, the tax implications of fund distributions must be taken into consideration. The most commonly made mistake in mutual fund investing is the so call buying-the-dividend, that is, buying mutual fund shares right before its dividend/capital gain distribution. When buying the dividend, the investor is responsible for paying current tax for the distribution. If you plan a large lump-sum investment in a mutual fund in your taxable account, to avoid buying-the-dividend, you should check the fund's distribution schedule and adjust your buying plan according.
However, this should be put in perspective. According to The Mutual Fund Education Alliance:
If the amount you're investing is fairly small, it's probably not worth waiting. And if you make regular investments every month, don't let buying the dividend derail your program. It's better to buy the dividend than to fail to invest.