Mutual Fund Capital Gains Distributions Definition and Taxation

What Are Mutual Funds Capital Gains Distributions?

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Mutual fund capital gains distributions are taxable events resulting from the fund's manager selling shares of securities held within the fund. These distributions are often misunderstood and can be unpleasant surprises for investors with taxable accounts. Taxes from capital gains distributions 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 taxes from mutual fund capital gains distributions.

Mutual Fund Capital Gains Distributions Definition

Each year, generally in 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 a stock due to the changing outlook, or even if the fund must simply raise cash for shareholder redemptions (shareholders sell shares of the fund), 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 the resulting taxes) to shareholders.

Mutual Funds Capital Gain Distribution Example

The capital gains distribution is taxable to the fund shareholders unless the fund is owned in a tax-deferred account (IRA, 401k, etc.). For example, let's say XYZ Mutual Fund purchased 100,000 shares of a stock 20 years ago for $1. The fund sells the 100,000 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.

Economic Value of Mutual Funds Capital Gain Distributions

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, looking further at the XYZ Mutual Fund distribution:

  • You own 1,000 shares of the XYZ Mutual Fund. The fund has a net asset value (NAV) of $10 per share. Your investment in the fund equals $10,000.
  • The total value of your holding in the fund is $10,000 (1,000 shares at $10 per share) and you reinvest all capital gains and dividends.
  • The fund distributes long-term capital gains as described in the previous example. The long-term capital gain upon the sale of stock in the previous example is 10% of the fund’s total net asset value or $1 per share.
  • Shareholders of record 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 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.

How? 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.

Do You Pay Taxes on Mutual Fund Capital Gains Distributions?

As previously mentioned, these capital gains distributions result in a tax bill if you own mutual funds in a taxable account. Retirement plans (IRAs, 401ks, etc.) are not impacted by capital gains distributions. Keep in mind, the reinvestment of the gains is added to your cost basis -- reducing 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 and tax-efficient mutual funds (even some actively managed funds have low turnover). 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. Indeed, you may want to sell the fund in order to avoid the distribution. If you sell the fund to avoid the distribution, be aware that if you buy the fund back within 30 days (either in your taxable account or in your IRA), you will run afoul of IRS wash sales rules.

Updated by Kent Thune, September 20, 2019. This information should not be construed as tax advice or as a recommendation to buy or sell securities.