Mutual Fund Capital Gains Distributions Definition and Taxation
What Are Mutual Funds Capital Gains Distributions?
Whenever mutual fund managers sell shares of securities held within a fund, capital gain taxes are triggered. Taxes from capital gains distributions are often misunderstood and can catch you off guard if you're not familiar with what they are and how they work. By learning the basics, educated investors can minimize the taxes owed from mutual fund capital gains distributions.
Capital Gains Distribution
Each year around November and December, mutual fund shareholders face the possibility of receiving capital gains distributions from their mutual funds. These capital gains distributions are the result of the management selling shares of one or more of the fund's holdings during the taxable year. 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, capital gains may occur. If the stock is trading higher than when the fund manager initially purchased it, the fund must distribute at least 95% of the gains and resulting taxes to shareholders.
The capital gains distribution is taxable to the fund shareholders unless it is owned in a tax-deferred account, such as an IRA or 401(k). For example, let's say XYZ Mutual Fund purchased 100,000 shares of a company 20 years ago for $1, and the fund sells the shares today for $50, which results in a long-term capital gain of $49 per share. The fund must distribute the gains to current shareholders, and the shareholders must report the gain on their personal tax return.
While it might seem like a positive to receive a capital gains distribution, there is actually no positive economic value to the distribution. For instance, let's look further at the XYZ Mutual Fund distribution example and assume you own 1,000 shares and reinvest all capital gains and dividends. If the fund has a net asset value (NAV) of $10 per share, your investment in the fund equals $10,000.
If the fund distributes long-term capital gains as described in the previous example, the long-term capital gain upon the sale of stock is 10% of the fund's total net asset value, or $1 per share. Shareholders on the record date will receive $1 for each share they own, and the NAV of the fund will be reduced by $1 on the ex-dividend date. As a result, you'll receive $1,000, which is automatically reinvested in the fund. Assuming no change in the market value, you still own $10,000 of the fund.
This is because the fund's NAV was reduced to $9 by the capital gains distribution of $1, and you reinvested the gain to give you a total of 1,111.11 shares ($1,000 reinvested in at the new NAV of $9 buys 111.11 shares). If you did not reinvest the gain, you would have 1,000 shares at $9 and $1,000 cash. Either way, you have $10,000.
Capital gains distributions result in a tax bill if you own mutual funds in a taxable account, but they do not impact retirement plans. The reinvestment of the gains is added to your cost basis, which reduces your taxable gain when the fund is eventually sold. If you own mutual funds in a taxable account, you may want to focus on low-turnover funds, which include index funds, tax-efficient mutual funds, and even some actively managed funds. Otherwise, you should consider visiting your fund company's website beginning in October of each year to determine if and when there will be capital gains distributions.
If the distributions are anticipated to be large, you should weigh the advantages and disadvantages of owning the fund—it's a chance that you may want to sell the fund to avoid the distribution. If so, be aware that if you repurchase the fund within 30 days (either in your taxable account or in your IRA), you will run afoul of IRS wash sales rules. A wash sale also happens if you sell a security at a loss and buy substantially identical securities within 30 days.
This information should not be construed as tax advice or as a recommendation to buy or sell securities.