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Nonqualified Dividends from bond mutual funds

My 1099-DIV tax form shows that most distributions from bond mutual funds are characterized as nonqualified dividends. If I am correct nonqualified dividends, similar to short-term capital gain distribution, are taxed as ordinary income and cannot be offset by investment loses, that makes them very disadvantageous for investors. Examples of such funds: PONDX, RSIVX , LSBRX, DSL, and bond portion of balanced funds PRWCX, VWINX.
Please explain whether it is always the case for bonds funds or I miss something.

Comments

  • edited February 2015
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  • @DavidV
    irs.gov
    There is a pamphlet available for download that will tell you what you need to know, for your particular circumstances, including the forms required for reporting and how to fill them out. Based on what you wrote, I think you need to read them...umm ... thoroughly (for the first time?). It is time to sit down and do the homework.

    I wish I could tell you that you'll only have to endure this challenge once, that from year-to-year there is little variation in the amount of losses that can be used to offset gains; however, with this do-nothing Congress, well.... that might not be the case for long--- (be afraid) they might actually do something.
  • You have the details correct. Let me try to describe this from the conceptual perspective (which may or may not help - different people understand things in different ways).

    Think about "regular" companies (like corporations). If you own shares of a company, you get dividends. Not interest - that's for the bond holders.

    Mutual funds are just companies ("regulated investment companies" - RICs). You own shares of a fund, you get dividends. Even MMFs are mutual funds, and they pay dividends.

    Under the 2003 Tax Act, dividends from domestic (and some foreign) corporations are to be treated as "qualified" dividends - taxed at a lower rate (and reported in box 1b on your 1099-DIV). It doesn't matter whether the corporation makes the money it distributes from selling widgets or from receiving interest on bonds it holds. The rationale given was that corporations are already paying taxes on their earnings, so investors shouldn't have to pay full freight a second time when they receive those earnings as dividends.

    But RICs are not corporations (and they don't pay corporate income taxes). For RICs, the Act says that only fund dividends that represent qualified dividends from the portfolio's corporate holdings are qualified (reported in box 1b). Since this income comes from corporations that have paid corporate taxes on it already, it makes sense to treat these dividends as qualified, even though they get to you via a mutual fund.

    Bond interest isn't corporate dividends (and no corporate taxes have been paid on this income). So when a fund distributes this to you as a dividend, it's not qualified. For that matter, capital gains generated by the fund are not qualified corporate dividends either.

    But there's an older special rule for capital gain dividends (IRC Section (b)(3)(B)) . It says that long term gains are to be reported in box 2, and taxed as capital gains. That makes sense as well, since the fund is acting as your "proxy" - buying and selling securities for you.

    What doesn't make a whole lot of sense, but has been in the rules "forever" is that short term gains generated by the fund get no special treatment. So they get reported as ordinary dividends (box 1a), and since they don't represent dividends from underlying stock, they don't get the special "qualified" treatment. Since they don't show up as short term gains on your 1099, you can't write off short term losses against them.

    The tax laws are complex, and there are a lot of competing interests embedded. But they can make a certain amount of sense - or perhaps one just needs a warped mind to appreciate them:-)
  • That's exactly why I pay someone to do them....and save me money everyyear
  • Great explanation, @msf. Thanks.
  • Thank you all for education.
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