Definition and Example Mutual Fund Capital Gains Distributions
Mutual fundshareholders face the possibility of receiving capital gains distributions from their mutual funds each year around November or December. These distributions are the result of the fund's managers selling shares of one or more of the fund's holdings during the tax year.
Capital gains can occur if the fund manager decides to sell stock due to the changing outlook, or even if the fund must simply raise cash for shareholder redemptions. The fund must distribute at least 95% of its gains and resulting taxes to shareholders if the stock is trading higher than when the fund manager initially purchased it.
These distributions are paid to you or credited to your mutual fund account, so they are considered your income. You do not have to sell shares of the mutual fund in order to have realized a capital gain.
Note
For stocks or bonds, a distribution occurs when you receive a payment of a dividend, interest, or principal from the issuer of the security.
How Does a Mutual Fund Capital Gains Distribution Work?
Suppose XYZ Mutual Fund purchased 100,000 shares of a company 20 years ago for $1. The fund sells the shares today for $50, which results in along-term capital gainof $49 per share. The fund must distribute the gain to current shareholders, who must report the gain on their personaltax returns.
Note
It might seem like a good thing to receive a capital gains distribution, but there's actually no positive economic value to the distribution.
Suppose you own 1,000 shares of XYZ Mutual Fund, and you reinvest all capital gains and dividends. Your investment in the fund equals $10,000 if the fund has anet asset value(NAV) of $10 per share.
The gain upon the sale of stock is 10% of the fund'stotal net asset value (NAV), or $1 per share, if the fund distributeslong-term capital gains. Shareholders will receive $1 for each share they own on the record date, and the NAV of the fund will be reduced by $1 on theex-dividend date.
Your account will receive $1,000 as a result. You'll still own $10,000 of the fund, assuming that there's no change in market value.
What It Means for Individual Investors
Capital gains distributions result in a tax bill if you own mutual funds in a taxable account, but they don't impact retirement accounts. The reinvestment of the gains is added to your cost basis, which lowers your taxable gain when the fund is eventually sold.
Visit your fund company's website at the start of in October of each year to find out whether and when there will be capital gains distributions. Weigh the pros and cons of owning the fund if you expect the distributions to be large. You might want to sell the fund to avoid the distribution and the tax bill that will come with it.
Keep in mind, though, that you'll run afoul ofthe Internal Revenue Service (IRS) wash sale rules if you buy the fund again within 30 days, either in yourtaxable accountor in your IRA. A wash sale happens when you sell or trade an asset at a loss and then, within 30 days either after or before the sale, you do the following:
- Buy substantially identical securities;
- Acquire substantially identical securities in a fully taxable trade; and/or
- Acquire a contract or option to buy substantially identical securities
Key Takeaways
- Mutual funds often sell shares of the fund’s holdings late in the year due to changes in the market or to raise cash.
- You can realize a long- or short-term capital gain as a result, causing taxes to be due.
- You can sell a fund to avoid distributions if you understand the rules.
- Distributions from funds held in a tax-advantaged account, such as a retirement plan, are not taxable.
If your trades fall under the wash sale rule, you won't be able to deduct the losses on your tax return. To prevent this result, think carefully before selling shares in your mutual fund. You want to be sure that avoiding the tax burden from capital gains distributions is worth disposing of your shares.
Frequently Asked Questions (FAQs)
Where do mutual fund capital gains go?
Mutual fund capital gains are usually reinvested into your account for you.
How can I offset capital gains mutual fund distributions to lower my income taxes?
Owning mutual funds through a retirement account will lower your income tax burden. You can also use tax-loss harvesting to offset capital gains with capital losses, which can lower or even eliminate your capital gains tax burden.
FAQs
One of the ways the fund makes money for you is to sell these assets at a gain. If the mutual fund held the capital asset for more than one year, the nature of the income from a sale of the capital asset is capital gain, and the mutual fund passes it on to you as a capital gain distribution.
How to avoid mutual fund capital gains distributions? ›
Look for funds that have a low turnover rate. This means that they tend to sell and move assets less frequently than other funds. The longer a mutual fund holds its assets, the less often it will generate sales and distributions. Also, look for funds that tend to reinvest profits rather than issuing distributions.
What is the difference between a dividend and a capital gain distribution? ›
A mutual fund dividend is income earned by the fund from dividends and interest paid by the fund's holdings. A capital gain distribution occurs when the fund sells assets during the year and the gains on those sales exceed the losses.
Is it better to sell mutual funds before capital gains distribution? ›
Some investors also may consider selling fund shares before a distribution to avoid the tax due. If the investor had gains on the shares at the time of the sale, the realized gains would be taxable in the year the shares were sold.
What is the capital distribution of funds? ›
What does Capital distribution mean? Also known as 'distribution'. These are the returns that an investor in a equity'>private equity fund receives. It is the income and capital realised from investments less expenses and liabilities.
Do I have to pay taxes on mutual fund capital gains distributions? ›
Holders of mutual fund shares are required to pay taxes on capital gains distributions made by the funds they own, whether or not the money is reinvested in additional shares. There is an exception for municipal bond funds, which are tax-exempt at the federal level and usually at the state level.
Are capital gains distributions taxable if reinvested? ›
Taxes on Reinvested Distributions
When these funds are held in a taxable account, you will pay taxes on the interest, dividends or capital gains in the year that you receive them, even if they are immediately reinvested back into the fund.
Do you pay more tax on dividends or capital gains? ›
Capital gains are charged with high tax amounts, while dividends have low taxes. Investors who get dividends vs. capital gains are applicable to pay tax on these gains. The tax on net capital gains depends on the asset being sold, whether long-term or short-term.
What is an example of a capital gain distribution? ›
For example, shares purchased for $100 and later sold for $120 generate a capital gain of $20. Gains from a fund distribution: If a mutual fund sells an underlying investment for more than it originally paid, it will realize a capital gain.
What is a downside of dividends and capital gains being reinvested in a mutual fund? ›
Taxes. You'll pay taxes on mutual fund distributions (unless the mutual funds are held in tax-advantaged accounts such as individual retirement, 401(k) and 403(b) accounts), whether you receive your distributions in cash or reinvest in additional fund shares.
Short-term capital gains (assets held 12 months or less) are taxed at your ordinary income tax rate, whereas long-term capital gains (assets held for more than 12 months) are currently subject to federal capital gains tax at a rate of up to 20%.
Can you offset mutual fund capital gains distributions with losses? ›
Gains and losses in mutual funds
Short-term capital gains distributions from mutual funds are treated as ordinary income for tax purposes. Unlike short-term capital gains resulting from the sale of securities held directly, the investor cannot offset them with capital losses.
What is the holding period for mutual funds for capital gains? ›
An individual can choose to invest in different types of Mutual Funds, like, equity funds, debt funds, and hybrid funds. If the holding period of any of these funds is less than 12 months (36 months in some cases), then the gain from the transfer of these funds is known as the short term capital gain from Mutual Funds.
What is an example of a mutual fund distribution? ›
Distributions are allocated to unitholders in proportion to the number of units they hold on a specific date, known as the “record date”. Example: If you held 100 mutual fund units on the record date, and the distribution was $0.50 per unit, you would receive a taxable distribution of $50.
How are capital gain distributions treated? ›
Long-term capital gain distributions are taxed at long-term capital gains tax rates; distributions from short-term capital gains and net investment income (interest and dividends) are taxed as dividends at ordinary income tax rates. Ordinary income tax rates generally are higher than long-term capital gains tax rates.
Are capital distributions tax free? ›
When capital dividends are paid out to shareholders, these are not taxable because the dividends are viewed as a return of the capital that investors pay in. When a company generates a capital gain from the sale or disposal of an asset, 50% of the gain is subject to a capital gains tax.
Can you offset mutual fund capital gain distributions? ›
Gains and losses in mutual funds
Keep a close eye on your funds' projected distribution dates for capital gains. Harvested losses can be used to offset these gains. Short-term capital gains distributions from mutual funds are treated as ordinary income for tax purposes.
How can I reduce my capital gains distribution? ›
Invest in Tax-Efficient Funds
The best way to avoid the capital gains distributions associated with mutual funds is to invest in exchange-traded-funds (ETFs) instead. ETFs are structured in a way that allows for more efficient tax management.
How to avoid the mutual fund tax trap? ›
Tactics for reducing your exposure to capital gains taxes
- Make sure your investments are in the appropriate accounts. ...
- Seek out tax-managed mutual funds. ...
- Consider swapping out your mutual funds for exchange-traded funds (ETFs). ...
- Explore the potential benefits of a separately managed account (SMA).
Distributions and your taxes
If you hold shares in a taxable account, you are required to pay taxes on mutual fund distributions, whether the distributions are paid out in cash or reinvested in additional shares. The funds report distributions to shareholders on IRS Form 1099-DIV after the end of each calendar year.
