The average annual return (AAR) is a percentage used when reporting the historical return, such as the three-, five-, and 10-year average returns of a mutual fund. The average annual return is stated net of a fund’s operating expense ratio. Additionally, it does not include sales charges, if applicable, or portfolio transaction brokerage commissions.
In its simplest terms, the average annual return (AAR) measures the money made or lost by a mutual fund over a given period. Investors considering a mutual fund investment will often review the AAR and compare it with other similar mutual funds as part of their mutual fund investment strategy.
Key Takeaways
The average annual return (AAR) is a percentage that represents a mutual fund’s historical average return, usually stated over three-, five-, and 10 years.
Before making a mutual fund investment, investors frequently review a mutual fund’s average annual return as a way to measure the fund’s long-term performance.
The three components that contribute to the average annual return of a mutual fund are share price appreciation, capital gains, and dividends.
Understanding the Average Annual Return (AAR)
When you are selecting a mutual fund, the average annual return is a helpful guide for measuring a fund’s long-term performance. However, investors should also look at a fund’s yearly performance to fully appreciate the consistency of its annual total returns.
For example, a five-year average annual return of 10% looks attractive. However, if the yearly returns (those that produced the average annual return) were +40%, +30%, -10%, +5% and -15% (50 / 5 = 10%), performance over the past three years warrants examination of the fund’s management and investment strategy.
Components of an Average Annual Return (AAR)
There are three components that contribute to the average annual return (AAR) of an equity mutual fund: share price appreciation, capital gains, and dividends.
Share Price Appreciation
Share price appreciation results from unrealized gains or losses in the underlying stocks held in a portfolio. As the share price of a stock fluctuates over a year, it proportionately contributes to or detracts from the AAR of the fund that maintains a holding in the issue.
For example, the American Funds AMCAP Fund’s top holding is Netflix (NFLX), which represents 3.7% of the portfolio’s net assets as of Feb. 29, 2020. Netflix is one of 199 equities in the AMCAP fund. Fund managers can add or subtract assets from the fund or change the proportions of each holding as needed to meet the fund’s performance objectives. The fund’s combined assets have contributed to the portfolio’s 10-year AAR of 11.58% through Feb. 29, 2020.
Capital Gains Distributions
Capital gains distributions paid from a mutual fund result from the generation of income or sale of stocks from which a manager realizes a profit in a growth portfolio. Shareholders can opt to receive the distributions in cash or reinvest them in the fund. Capital gains are the realized portion of AAR. The distribution, which reduces share price by the dollar amount paid out, represents a taxable gain for shareholders.
A fund can have a negative AAR and still make taxable distributions. The Wells Fargo Discovery Fund paid a capital gain of $2.59 on Dec. 11, 2015, despite the fund having an AAR of negative 1.48%.
Dividends
Quarterly dividends paid from company earnings contribute to a mutual fund’s AAR and also reduce the value of a portfolio’s net asset value (NAV). Like capital gains, dividend income received from the portfolio can be reinvested or taken in cash.
Large-cap stock funds with positive earnings typically pay dividends to individual and institutional shareholders. These quarterly distributions comprise the dividend yield component of a mutual fund’s AAR. The T. Rowe Price Dividend Growth Fund has a trailing 12-month yield of 1.36%, a contributing factor to the fund’s three-year AAR of 15.65% through Feb. 29, 2020.
Special Considerations
Calculating an average annual return is much simpler than the average annual rate of return, which uses a geometric average instead of a regular mean. The formula is: [(1+r1) x (1+r2) x (1+r3) x … x (1+ri)] (1/n) – 1, where r is the annual rate of return and n is the number of years in the period.
The average annual return is sometimes considered less useful for giving a picture of the performance of a fund because returns compound rather than combine. Investors must pay attention when looking at mutual funds to compare the same types of returns for each fund.
AAA is the highest possible rating that may be assigned to an issuer’s bonds by any of the major credit-rating agencies. AAA-rated bonds have a high degree of creditworthiness because their issuers are easily able to meet financial commitments and have the lowest risk of default.
Rating agencies Standard & Poor’s (S&P) and Fitch Ratings use the letters “AAA” to identify bonds with the highest credit quality, while Moody’s uses a slightly different “Aaa” to signify a bond’s top-tier credit rating.
Key Takeaways
The highest possible rating that a bond may achieve is AAA, which is only bestowed upon those bonds that exhibit the highest levels of creditworthiness.
This AAA rating is used by Fitch Ratings and Standard & Poor’s, while Moody’s uses the similar “Aaa” lettering.
Bonds that receive AAA ratings are viewed as the least likely to default.
Issuers of AAA-rated bonds generally have no trouble finding investors, although the yield offered on these bonds is lower than other tiers because of the high credit rating.
Understanding AAA
Since AAA-rated bonds are perceived to have the lowest risk of default, these instruments tend to offer investors the lowest yields among bonds with similar maturity dates (lower risk = lower return). The term “default” refers to a bond issuer failing to fulfill its obligations, namely failing to make semiannual interest payments or repay the principal amount when due.
AAA ratings are given to government debt and companies’ corporate bonds. The global credit crisis of 2008 resulted in a number of companies losing their AAA rating, most notably General Electric (GE). As of September 2022, only two companies held the AAA rating outright: Microsoft (MSFT) and Johnson & Johnson (JNJ). Apple (AAPL) is split, with a Aaa rating by Moody’s and a AA+ (one notch below AAA) from S&P.
Even the United States suffered a ratings cut by S&P, to AA+ in 2012—losing its vaunted AAA status due to political infighting over raising the debt ceiling. Moody’s and Fitch maintained the U.S. at Aaa and AAA ratings, respectively.
Rather than restricting their fixed-income exposure to AAA-rated bonds, investors should consider balancing those investments with higher income-producing bonds, such as high-yield corporates.
Types of AAA Bonds
Municipal
Municipal bonds can be issued as either revenue bonds or general obligation bonds—with each type relying on different sources of income.
Revenue bonds, for example, are paid using fees and other specific income-generating sources, like city pools and sporting venues. On the other hand, general obligation bonds are backed by the issuer’s ability to raise capital through levying taxes. Pointedly: State bonds rely on state income taxes, while local school districts depend on property taxes.
Secured and Unsecured
Issuers can sell both secured and unsecured bonds. Each type of bond carries with it a different risk profile.
A secured bond means that a specific asset is pledged as collateral for the bond, and the creditor has a claim on the asset if the issuer defaults. Secured bonds may be collateralized with tangible items such as equipment, machinery, or real estate. Secured collateralized offerings may have a higher credit rating than unsecured bonds sold by the same issuer.
Conversely, unsecured bonds are simply backed by the issuer’s promise to pay. Therefore, the credit rating of such instruments relies heavily on the issuer’s income sources and business outlook.
Benefits of a AAA Rating
A high credit rating lowers the cost of borrowing for the issuer (or borrower). Therefore, it stands to reason that companies with high ratings are better positioned to borrow large sums of money than fixed-income instruments with lesser credit ratings. And a low cost of borrowing affords firms a substantial competitive advantage by letting them easily access credit to grow their businesses.
For example, a business may use the incoming funds from a new bond issue to launch a new product line, set up shop in a new location, or acquire a competitor. All of these initiatives can help a company increase its market share and thrive over the long haul.
Why is a credit rating so important?
The level of credit rating that an issuer receives has significant implications on the cost of borrowing in the open market. The better the credit rating—with AAA being the best—the lower the cost to borrow, and vice versa.
For investors, you’ll need to balance the risk you’re willing to take against the yield you’re seeking.
Who decides what credit rating a debt issuer receives?
There are three major credit rating agencies: Standard & Poor’s (S&P), Moody’s, and Fitch. They assess a debt issuer’s creditworthiness and ability to pay interest and principal on bonds based on multiple factors, such as the company’s cash flow, amount of other outstanding debt, and the business outlook for the issuer, to name just a few criteria.
What does the AAA credit rating mean?
The AAA credit rating is only given to the most creditworthy debt issuers and allows investors to gauge the amount of risk in their fixed-income portfolio. Conservative investors will typically sacrifice return or yield to own the highest credit rating issues available.
The Bottom Line
Credit ratings are assigned to debt issues and bonds by the three major debt-rating agencies: S&P, Moody’s, and Fitch. Their credit ratings have a strong influence on the cost of borrowing for the issuer. The better the credit rating, the lower the cost to borrow.
AAA/Aaa ratings are the highest ratings issued by the credit-rating agencies and likely result in the lowest borrowing costs or yields. Investors seeking a better return should look down the credit-ratings scale for bond issuers with lower ratings and higher yields.
Form 1040-A of the Internal Revenue Service (IRS) was a simplified version of Form 1040 used by U.S. taxpayers to file an annual income tax return. To have been eligible to use Form 1040-A, an individual needed to meet certain requirements such as not itemizing deductions, not owning a business, and having a taxable income of less than $100,000. Unofficially known as the “short form,” Form 1040-A was eliminated for the 2018 tax year in favor of the redesigned Form 1040 that debuted that year.
Key Takeaways
Form 1040-A was a simplified version of Form 1040 used for filing individual income tax.
Filers using 1040-A were required to have less than $100,000 in taxable income and not have exercised any incentive stock options during the year.
The IRS eliminated Form 1040-A for the 2018 tax year in favor of the redesigned Form 1040.
Another variant of Form 1040 was Form 1040-EZ, which was even simpler than Form 1040-A and was also eliminated starting with the 2018 tax filing.
Who Had to File Form 1040-A: U.S. Individual Tax Return?
Most U.S. taxpayers use IRS Form 1040 to file their income tax returns. Form 1040 is a detailed form that offers taxpayers with complex investments, itemized deductions, multiple tax credits, and more than $100,000 in annual income more opportunities to lower their tax liability. Because additional paperwork is usually required with Form 1040, individuals with simpler tax situations previously had the option to use Form 1040-A instead.
Form 1040-A was a simplified version of Form 1040. The two-page form allowed taxpayers to report ordinary income, some deductions, and credits. Individuals who fell under any of the five status options—single, head of household, married filing separately, married filing jointly, or widowed—could file their tax returns using the 1040-A. Though Form 1040-A was available to taxpayers of any age and filing status, not everyone qualified to use this form.
Tax filers who used 1040-A must have earned less than $100,000 taxable income and not have exercised any incentive stock options (ISO) during the tax year. The income reported must have been earned as a wage, salary, tip, capital gain, dividend, interest income, unemployment compensation, pension, annuity, taxable Social Security and railroad retirement benefit, taxable scholarship or grant, and Alaska Permanent Fund dividend. Any other form of income, such as business income, needed to be reported on the more complex Form 1040.
How Did Form 1040-A Work?
Form 1040-A also gave taxpayers the opportunity to claim several tax deductions to reduce their taxable income. However, the only deductions they could claim included student loan interest, post-secondary tuition and fees, classroom expenses, and individual retirement account (IRA) contributions. Taxpayers using Form 1040-A could not claim itemized deductions. This limitation meant that if an individual qualified for other deductions from sources such as charitable donations or mortgage interest, and the total itemized deductible amount was more than the standard deductions, it would not have been advantageous for them to use 1040-A.
Form 1040-A also could be used to claim tax credits. Tax credits reduce the bottom line or total tax bill of a taxpayer. The credits that could be claimed using this form were the American Opportunity Tax Credit (AOTC), Earned Income Credit (EITC), child tax and additional child tax credit, child and dependent care credit, credits for the elderly or disabled, and retirement savings contribution credit.
Form 1040-A vs. Form 1040-EZ
Another variant of Form 1040 was Form 1040-EZ, which was even simpler and easier to fill out than Form 1040-A and was also eliminated starting with the 2018 tax filing. But with Form 1040-EZ, the individual had to file as either a single taxpayer or as married filing jointly; they could not claim deductions and could only claim the EIC.
Although Form 1040-A was slightly more complex than Form 1040-EZ, it was still relatively simple compared to 1040. Once their financial situation became complicated with dependents, special deductions, and credits—such as those associated with post-secondary education tuition—most taxpayers needed to switch from filing with the 1040-EZ to the 1040-A.
The redesigned Form 1040 that debuted with the 2018 tax year is designed to be much simpler to use than its predecessor. For this reason, the IRS eliminated both Form 1040-A and Form 1040-EZ.
Form 1040 is the standard Internal Revenue Service (IRS) form that individual taxpayers use to file their annual income tax returns. The form contains sections that require taxpayers to disclose their taxable income for the year to determine whether additional taxes are owed or whether the filer will receive a tax refund.
Key Takeaways
Form 1040 is what individual taxpayers use to file their taxes with the IRS.
The form determines if additional taxes are due or if the filer will receive a tax refund.
Taxpayers must include personal information on Form 1040, such as name, address, Social Security number, and the number of dependents.
A filer also needs to report wages, salary, taxable interest, capital gains, pensions, Social Security benefits, and other types of income.
Taxpayers may need to file supplemental tax 1040 forms depending on their situation.
Understanding Form 1040
Form 1040 needs to be filed with the IRS by April 15 in most years. Everyone who earns income over a certain threshold must file an income tax return with the IRS. Keep in mind that businesses have different forms to report their profits.
Form 1040 is available on the IRS website and has two pages that must be filled out. Form 1040 can be mailed in or e-filed. Tax filers are asked for their filing status along with their personal information, such as their name, address, Social Security number (some information on one’s spouse may also be needed), and the number of dependents. The form also asks about full-year health coverage and whether the taxpayer wishes to contribute $3 to presidential campaign funds.
Form 1040 (Page 1).
The 1040 income section asks the filer to report wages, salary, taxable interest, capital gains, pensions, Social Security benefits, and other types of income. The new tax legislation eliminated many deductions, including for unreimbursed employee expenses, tax-preparation fees, and moving for a job (except for military on active duty).
Form 1040 (Page 2).
The form uses what the IRS terms a building block approach and allows taxpayers to add only the schedules they need to their tax returns. Some individuals may need to file one or more of six new supplemental schedules with their 1040 in addition to long-standing schedules for items like business income or loss. This depends on whether they’re claiming tax credits or owe additional taxes. Many individual taxpayers, however, only need to file a 1040 and no schedules.
Types of Form 1040
Taxpayers in certain situations may need to file a different variant of the 1040 form instead of the standard version. Below are the options.
Form 1040-NR
A number of nonresident aliens or their representatives need to file this form, including:
Those who are engaged in trade or business in the United States
Representatives of a deceased person who would have had to file a Form 1040-NR
Those who represent an estate or trust that had to file a 1040-NR
Form 1040-NR replaced Form 1040NR-EZ.
The IRS also produces the 1040-SS and 1040-PR. The 1040-SS is for residents of American Samoa, the CNMI, Guam, Puerto Rico, or the U.S. Virgin Islands who have net self-employment income and do not have to file Form 1040 with the U.S. Form 1040-PR is the Spanish-language equivalent of Form 1040-SS.
Form 1040-ES
This form is used to determine and pay estimated quarterly taxes. The estimated tax applies to income that isn’t subject to withholding, which includes earnings from self-employment, interest, dividends, and rents. This may also include unemployment compensation, pension income, and the taxable portion of Social Security benefits.
Form 1040-V
This is a statement accompanying a taxpayer’s payment for any balance on the “Amount you owe” line of the 1040 or 1040-NR.
Form 1040-X
If a filer makes a mistake or forgets to include information on any 1040 form, Form 1040-X is used for making changes to previously filed 1040s.
Form 1040-SR
The IRS introduced a new 1040 form for seniors in 2019, Form 1040-SR. Changes include a larger font, no shading (shaded sections can be hard to read), and a standard deduction chart that includes the extra standard deduction for seniors. Seniors who fill out their taxes online won’t notice the difference, but those who do it on paper should benefit.
Standard Deductions on Form 1040
The 1040 income section asks taxpayers for their filing status. This filing determines the taxpayer’s standard deduction. The table below highlights the deductions for the 2022 and 2023 tax years. Keep in mind that you file 2022 taxes in 2023 and 2023 taxes in 2024.
An additional deduction may be taken by those who are age 65 or older or blind. Just like the standard deduction, these figures are adjusted annually for inflation.
Single and not widowed: $1,750 (for 2022) and $1850 (for 2023)
Married filing jointly: $1,400 (2022) and $1,500 (2023) for each spouse who is 65 or older or blind
The standard deduction cannot be taken by an estate or trust, an individual who is filing a short return due to a change in accounting periods, an individual who was a nonresident alien part of the tax year, or a married individual whose spouse is filing separately and itemizing.
Additional Schedules
As noted above, Form 1040 uses a variety of additional schedules to help taxpayers report their tax obligations. The following schedules are used to compile financial information away from Form 1040 to later use Form 1040 as the primary source of reporting.
Schedule 1
Schedule 1 is used to report additional income or adjustments to income. This may include alimony, disposition proceeds from the sale of a business, educator expenses, health savings account (HSA) contributions, or unemployment compensation.
It’s important to note that:
Other Income from Schedule 1: This is reported on Line 8 of Form 1040
Adjustments to Income from Schedule 1: This is reported on Line 10 of Form 1040
Schedule 2
Schedule 2 is used to report additional taxes. One part of Schedule 2 reports alternative minimum tax and repayment of excess premium tax credits for insurance bought through health insurance marketplaces.
Another part of Schedule 2 is used to report self-employment taxes, Medicare taxes, taxes on individual retirement accounts (IRAs), household employment taxes, and other taxes. These two parts from Schedule 2 are reported on Line 17 and line 23 on Form 1040.
Schedule 3
Schedule 3 is used to report additional tax credits and payments. These credits include dependent care expense credits, residential energy credits, excess social security taxes previously remit, and excess Federal income taxes previously remit.
Nonrefundable credits from Schedule 3 are reported on Line 20 of Form 1040, while refundable credits from Schedule 3 are reported on Line 31 of Form 1040.
Schedule A (Itemized Deductions)
Schedule A is used to figure out a taxpayer’s itemized deduction. A taxpayer’s federal income liability is most often minimized when choosing the larger of their standard deduction or itemized deduction.
The itemized deduction calculation includes medical expenses, dental expenses, certain taxes, certain interest assessments, theft losses, and other expenses. Any input from Schedule A is entered into Line 12a on Form 1040.
Schedule B (Interest and Ordinary Dividends
Schedule B is used for taxpayers who received greater than $1,500 of taxable interest or ordinary dividends. It is also used to report interest from a seller-financed mortgage, accrued interest from a bond, interest or ordinary dividends as a nominee, and other similar types of interest. Input from Schedule B is entered into Line 2b and Line 3b on Form 1040.
Schedule C (Net Profit From Business)
Schedule C is used to report business income or loss. An activity qualifies as a business if the taxpayer is engaged in the activity for the primary purpose of producing income or profit. The activity is also considered a business as long as the taxpayer is involved in the activity with regularity and continuity. Profit from Schedule C is entered on Schedule 1, Line 3. It is also used on Schedule SE.
If your business was a sole proprietorship or qualified join venture and you meet other criteria, you can report your business operations using Schedule C-EZ, a simplified schedule compared to Schedule C.
Schedule D (Capital Gains and Losses)
Schedule D is used to report taxable income from the sale or exchange of a capital asset. This gain may have arisen from an exchange or an involuntary conversion. Schedule D is also used to report capital gain distributions not otherwise reported on Form 1040 as well as nonbusiness bad debts. Input from Schedule D is entered on Form 1040, Line 7.
Schedule E (Supplemental Income and Loss)
Schedule E is used to report various types of additional income or losses. This supplemental financial activity ranges from real estate rental income, royalties, partnerships, estates, trusts, and residual interests in real estate mortgage investment conduits. Supplemental income figures from Schedule E are reported on Form 1040 on Line 5.
Schedule EIC (Earned Income Credit)
Schedule EIC is quite different from other tax schedules. The earned income credit is calculated separately from this schedule. However, Schedule EIC is used to substantiate the qualification of your qualifying children by remitting to the IRS your child’s name, Social Security number, birth year, relationship to you, and residency status. Information from Schedule EIC is not directly input into Form 1040.
The Earned Income Credit is maximized if a taxpayer has at least three children. Therefore, Schedule EIC only asks for information on three children; additional forms for additional children beyond three is not required.
Other Schedules
Other notable supplementary schedules to Form 1040 include:
Schedule F is used to report profits or losses from farming operations
Schedule H is used to report household employment taxes if you paid cash wages to household employees and those wages were subject to various Federal taxes
Schedule J is used to report farming or fishing trade income by averaging taxable income over the previous three years
Schedule R is used to report a credit for the elderly or disabled
Schedule SE is used to report the tax due on net earnings from self-employment
Schedule 8812 is used to report potentially refundable credits for qualifying children (or other dependents)
Who Needs to File Form 1040
If a United States citizen wants to or needs to file a Federal income tax return, they need to file Form 1040 or a variation of Form 1040 mentioned above. There are three general conditions to consider regarding whether an individual needs to file.
First, the IRS requires individuals with certain levels of gross income to file taxes. This threshold varies based on the individual’s filing status and age. The table below lists the income limits for individuals under 65 years old. Keep in mind that older taxpayers tend to have higher thresholds, and the threshold changes if neither, one, or both individuals in a marriage are 65 or older.
2022 Gross Income Thresholds
Filing Status
Gross Income
Single
$12,950
Married Filing Jointly
$25,900
Married Filing Separately
$5
Head of Household
$19,400
Qualifying Widow(er)
$25,900
Individuals with the gross income amounts below are required to file 2022 federal income taxes.
Children and dependents may not be required to file if they can be claimed as a dependent. If the dependent’s unearned income is greater than $1,100, earned income was greater than $12,550, or gross income meets certain thresholds, the dependent must file their own Form 1040. These rules are slightly different for single dependents as opposed to dependents who are married.
Finally, there are some specific situations that require an individual to file Form 1040. Regardless of their income or dependency status, some of those situations include but are not limited to:
You owe additional special taxes such as alternative minimum tax
You receive HSA or other health account distributions
You had net earnings from self-employment of at least $400
You met the income threshold limits for wages earned from a church
What Is Form 1040 Used for?
Form 1040 is the primary tax form used by U.S. taxpayers to file their annual income tax returns. Taxpayers input their personal information and tax information onto the form, then submit the form to the IRS for review.
Is Form 1040 the Same As a W-2?
Form 1040 is different than a W-2. A W-2 is a wage and tax statement an employee receives from a company they worked for during the tax year. The information listed on the W-2 is used to fill out Form 1040.
Where Can I Find Form 1040?
Form 1040 is not a tax statement or form that gets distributed to taxpayers. Unlike a W-2 or 1099 statement that is mailed by an employer or party you’ve contracted with, Form 1040 is available for download on the IRS website. In addition, free IRS filing platforms such as Free File Fillable Forms will provide digital copies. Last, some public courthouses or Federal buildings in your community may offer paper copies available for pick-up.
What Is the Difference Between a 1040 and 1099?
Form 1040 and Form 1099 are different components to an individual’s tax return. There are many different types of Form 1099, but Form 1099 is most commonly given to independent contractors to remit tax information relating to payments they received during the tax year. This information is used to complete Form 1040, as the financial records listed on Form 1099 are input into Form 1040.
The Bottom Line
Form 1040 is the central part of tax filing for United States citizens. It is the tax form that all taxpayer financial statements eventually feed into and supporting tax schedules branch out of. Regardless of an individual’s filing status or income, taxpayers who file taxes will complete some version of Form 1040.
