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Mutual funds held in taxable accounts are subject to a wide range of distributions rules. This can make the taxability of income and capital gain distributions you receive seem unfair or overly complex. This guide will walk you through a variety of fund distribution rules to help you better understand why the money you receive from your funds is taxed the way it is.

1. Flow-Through. Funds themselves are not taxed at a corporate level; instead, they pass on their dividends and capital gains to shareholders, who then declare and pay taxes on them. This might seem similar to partnership taxation, where all activity is passed through to the partners; however, unlike partnerships, funds cannot flow through losses.
2. Corporate Dividends. Most people pay favorable tax rates on corporate dividends. Dividend tax rates range from 0 percent for low-income taxpayers up to 20 percent for higher-income taxpayers; however, most people pay 15 percent. There are certain circumstances where you can lose the tax-favored rates from fund distributions. For example, dividends from real estate investment trusts often do not qualify for the low rates. Additionally, certain funds often lend securities to short-sellers. Payments received from the short-sellers to replace the missing dividends are considered substitute payments and do not receive favorable tax rates.
3. Hot Potato Rule. Distributions and their accompanying tax bill are passed through to whoever is holding the fund when the distribution goes out. Say you purchased a fund for $25 per share and then a few weeks later receive a distribution of $2 with the fund immediately dropping in value to $23. Technically, you are breaking even; however, you are responsible for the tax liability on the distribution. One way to prevent problems like this is to avoid buying funds when large lump sum distributions are likely.
4. Municipal Interest. Funds that own municipal bonds sold by states, cities and certain other organizations are allowed to pass through the federally tax-exempt interest to its investors. The catch is that the fund must hold at least 50 percent of its assets invested in these municipal bonds. If the fund falls below this level, then none of the distributions receive tax-exempt treatment.
5. Treasury Interest. Most states do not make you pay tax on the interest earned on U.S. Treasury debt. However, certain states have a rule similar to the municipal interest rule, whereas the interest is tax exempt only if a certain percentage of the fund’s assets are invested in treasury debt. States with tricky rules on treasury debt include California, Connecticut and New York.
6. Foreign Tax Credit. Funds can pass through a federal tax credit for foreign taxes, allowing you to claim the foreign taxes paid on your behalf by the fund.

As you can see, there are a variety of rules that affect the taxability of distributions you receive from your funds. This makes it important to understand the underlying rules and operations of the funds you invest in, especially if tax considerations are part of your investment strategy. Consult a tax professional for advice on your particular situation.