Are All Mutual Funds Tax-Exempt? What Investors Should Know

A mutual fund’s tax status depends on the assets it holds, not its structure. Funds that invest in corporate stocks and bonds will generate taxable income for investors. To achieve tax-exempt status, a fund must invest in specific securities that produce tax-free income.

The tax rules also change depending on the account type. Funds held in a standard brokerage account are subject to annual taxes, while those in a tax-advantaged retirement account can defer or eliminate this tax burden.

How Mutual Funds Generate Taxable Events

A mutual fund in a standard brokerage account can create tax liabilities for an investor in several ways. These taxable events stem from activity within the fund and the investor’s actions. The fund passes along income and realized gains to its shareholders, and these distributions are taxable in the year they are received.

Dividend Distributions

Mutual funds generate taxable income through the distribution of dividends. The underlying companies in a stock fund may pay dividends, or the bonds in a bond fund may pay interest. The mutual fund collects this income and distributes it to its shareholders, which is considered taxable income whether taken as cash or reinvested.

The tax rate applied to these dividends depends on their classification. Qualified dividends are taxed at long-term capital gains rates, which for 2025 are 0%, 15%, or 20%, depending on the investor’s taxable income. To be considered qualified, dividends must be paid by a U.S. or qualifying foreign corporation, and the investor must meet certain holding period requirements. Non-qualified dividends are taxed at the investor’s ordinary income tax rate, which can be as high as 37%.

Capital Gains Distributions

A mutual fund also creates a taxable event when it distributes realized capital gains. Throughout the year, a fund’s manager buys and sells securities. If a security is sold for more than its purchase price, the fund realizes a capital gain and must distribute these net gains to shareholders annually.

This distribution is taxable to the investor, even if they have not sold any of their fund shares. Gains from assets the fund held for over a year are distributed as long-term capital gains and are taxed at the 0%, 15%, or 20% rates. Gains from assets held for one year or less are distributed as short-term capital gains and are taxed at the investor’s higher ordinary income tax rate.

Selling Your Mutual Fund Shares

An investor also creates a taxable event by selling their mutual fund shares. The sale results in a capital gain or loss, which is calculated by subtracting the investor’s cost basis from the sale price. The cost basis is the original purchase price of the shares, including any reinvested dividends and capital gains distributions.

If the shares were held for more than one year, the profit is considered a long-term capital gain and is taxed at the preferential rates. If the shares were held for one year or less, the profit is a short-term capital gain, taxed at the investor’s ordinary income tax rate.

The Nature of Tax-Exempt Mutual Funds

Tax-exempt mutual funds are designed to generate income that is free from federal income tax. These funds achieve this by investing primarily in municipal bonds, which are debt securities issued by states, cities, and other local government entities. The interest income paid by these municipal bonds is the source of the fund’s tax-exempt distributions.

Federal Tax Exemption

Income distributed by a tax-exempt mutual fund is not subject to federal income tax. This benefits investors in higher tax brackets, as they avoid paying their ordinary income tax rate on this investment income. This is a direct contrast to the interest received from a corporate bond fund.

State and Local Taxes

While income from a municipal bond fund is federally tax-exempt, it may still be subject to state and local income taxes. Interest income is typically free from state and local taxes only if the investor lives in the same state that issued the bonds. For example, a California resident investing in a California-specific municipal bond fund may receive income free from federal, state, and local taxes, a status known as “triple-tax-exempt.” An investor in a national municipal bond fund will likely pay state and local taxes on income from out-of-state bonds.

Capital Gains Exception

The tax exemption applies only to the interest income distributed by the fund. If an investor sells their shares of a tax-exempt mutual fund for a profit, that profit is a capital gain. This gain is fully taxable at the federal, state, and local levels.

Alternative Minimum Tax (AMT)

A caveat to the tax-exempt status involves the Alternative Minimum Tax (AMT), a parallel tax system for high-income individuals. Interest from certain “private activity” municipal bonds, used to finance projects like airports, is taxable for AMT purposes. If a municipal bond fund holds these bonds, a portion of its income may become taxable for an investor subject to the AMT.

Tax Implications Within Retirement Accounts

The tax treatment of mutual funds changes when held inside a tax-advantaged retirement account, such as a 401(k) or an Individual Retirement Arrangement (IRA). These accounts act as a “tax wrapper,” altering how investment growth is taxed. The fund’s internal activities, like dividend and capital gains distributions, no longer create an immediate tax bill for the investor.

Tax-Deferred Accounts (Traditional IRAs, 401ks)

In tax-deferred accounts like traditional IRAs and most 401(k)s, contributions may be pre-tax, reducing current taxable income. Inside the account, dividends and capital gains are not taxed when received, allowing investments to grow tax-deferred. Taxes are paid only upon withdrawal, at which point the money is taxed as ordinary income.

Tax-Free Accounts (Roth IRAs, Roth 401ks)

Roth accounts, such as Roth IRAs and Roth 401(k)s, are funded with after-tax dollars, so there is no upfront deduction. The benefit is that all investment growth, including dividends and capital gains, is tax-free. Qualified withdrawals in retirement are also entirely free of federal income tax.

Inefficiency of Tax-Exempt Funds in Retirement Accounts

Holding a tax-exempt municipal bond fund within a retirement account is an inefficient strategy. The main benefit of a municipal bond fund is its tax-exempt income, but retirement accounts already provide tax deferral or tax-free growth. Since municipal bonds offer lower yields than comparable taxable bonds to compensate for their tax benefits, holding them in a tax-advantaged account wastes the exemption and results in lower returns than a higher-yielding taxable bond fund.

Understanding Your Mutual Fund Tax Forms

Each year, investors with mutual funds in taxable accounts receive tax forms reporting the previous year’s activity. These documents provide the figures needed to file your tax return. The two most common forms are Form 1099-DIV and Form 1099-B.

Form 1099-DIV, Dividends and Distributions

You will receive Form 1099-DIV if you received $10 or more in dividends or distributions from a mutual fund. This form details the different types of distributions you received. Box 1a shows the total amount of ordinary dividends, while Box 1b reports the portion of that total that consists of qualified dividends, which are eligible for lower tax rates. Box 2a reports the total capital gain distributions paid out by the fund. For investors in tax-exempt funds, Box 12 will report the amount of tax-exempt interest dividends received, which must still be reported on your tax return even though it is not federally taxed.

Form 1099-B, Proceeds from Broker and Barter Exchange Transactions

If you sold or exchanged mutual fund shares during the year, you will receive Form 1099-B. This form reports the sale details needed to calculate your capital gain or loss. It shows the gross proceeds from the sale in Box 1d and the cost basis in Box 1e. The difference is your gain or loss, which you must report on Schedule D and Form 8949.