Mutual funds capital gains distributions occur whenever mutual fund managers sell shares of securities held within a fund. These distributions are taxable to the fund shareholders unless the fund is owned in a tax-deferred account, such as an IRA or 401(k).
Taxes from capital gains distributions can catch you off guard if you're not familiar with what they are and you're not expecting them. Educated investors can minimize the taxes owed from mutual fund capital gains distributions by learning the basics.
What Is a Capital Gains Distribution?
Mutual fund shareholders face the possibility of receiving capital gains distributions from their mutual funds each year around November or December. These distributions are the result of management selling shares of one or more of the fund's holdings during the taxable 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.
How Does a Capital Gains Distribution Work?
Let's say 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 a long-term capital gain of $49 per share. The fund must distribute the gain to current shareholders, and the shareholders must report the gain on their personal tax returns.
It might seem like a good thing to receive a capital gains distribution, but there's actually no positive economic value to the distribution.
Assume 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 a net asset value (NAV) of $10 per share.
The gain upon the sale of stock is 10% of the fund's total net asset value, or $1 per share, if the fund distributes long-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 the ex-dividend date. You'll receive $1,000 as a result, which is automatically reinvested in the fund.
You still own $10,000 of the fund, assuming that there's no change in market value.
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 works out to 111.11 shares. You would have 1,000 shares at $9 and $1,000 cash if you didn't reinvest the gain. Either way, you have $10,000.
Do I Need to Pay Capital Gains Tax?
Capital gains distributions result in a tax bill if you own mutual funds in a taxable account, but they don't 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.
Consider visiting your fund company's website beginning in October of each year to determine if and when there will be capital gains distributions. Weigh the advantages and disadvantages of owning the fund if the distributions are anticipated to be large. You might want to sell the fund to avoid the distribution.
Keep in mind, however, that you'll run afoul of IRS wash sales rules if you repurchase the fund within 30 days, either in your taxable account or in your IRA. A wash sale also happens if you sell a security at a loss and buy substantially identical securities within 30 days.
- Mutual funds often sell shares of one or more of the fund’s holdings late in the year.
- These distributions can occur due to changes in the market or because the fund has to raise cash.
- You could realize a long- or short-term capital gain as a result, bringing taxes due.
- You can sell a fund to avoid distributions if you understand the rules.
- Taxes on these distributions don’t affect retirement plans.