Mutual Fund Short-Term Capital Gains Distributions

Short-Term Capital Gains vs. Short-Term Capital Gains Distributions

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Taxation is already a complex topic to understand, but the taxation of mutual fund short-term capital gains is one of the least understood topics in the investment universe. While most investors are knowledgeable about short-term capital gains, understanding short-term capital gains distributions of mutual funds can be much more difficult for many investors.

Here's what you should know about how mutual fund short-term capital gains are distributed to shareholders.

What Are Mutual Fund Capital Gains Distributions?

Each year, mutual fund shareholders face the prospect of receiving capital gains distributions from their mutual funds. These capital gains distributions are the result of the mutual fund selling securities within the fund. For instance, a mutual fund may start out the year holding a stock like General Electric. Then, during the year, the fund manager may decide to sell those shares at a capital gain. When they do so, they must pass those gains onto the shareholders. This is typically done in lump sums at the end of the year—all the gains from all the sales throughout the year are distributed among shareholders in one payment.

You can avoid tax liability on these distributions (at least temporarily) by holding mutual funds in a tax-deferred account, such as a 401(k), 403(b), or IRA.

Long-Term vs. Short-Term Capital Gains Distributions

If a mutual fund sells the shares it has owned for one year or less, any gains as a result of that sale are considered "short-term capital gains" and are distributed to shareholders as short-term capital gains distributions. These distributions are taxed at the same rate as ordinary income.

If a mutual fund sells shares that it has owned for more than 12 months, however, then any gains as a result of the sale are classified as "long-term capital gains" and are distributed as long-term capital gains distributions. Long-term capital gains are subject to long-term capital gains taxes, which are more favorable than ordinary income tax rates.

Shareholders may face both long-term and short-term capital gains distributions as a result of owning shares in a particular mutual fund, regardless of how long the fund has been held. Remember, the applicable time frame is based on the mutual fund's holding period for the securities within the mutual fund, not how long the mutual fund's shareholder has held the mutual fund itself.

Short-Term Capital Gains Distributions

The difference between short-term capital gains and short-term capital gains distributions is what may confuse investors. For instance, if you own a mutual fund for a few months and then sell it for a gain, you have incurred a short-term capital gain. If the fund was held in a taxable account, and you don't have enough losses to offset this gain, the net result is a short-term gain, and you will have to pay ordinary income tax rates on the amount of money you made as a result of the sale.

In the previous scenario, in which you gained from buying and selling shares in the mutual fund, you can use any short-term gains you might realize against other capital losses to reduce your tax liability. That's important to know, because it isn't quite the case when it comes to short-term capital gains distributions from a mutual fund.

Instead, if you own a mutual fund that subjects you to short-term capital gains distributions, then you must report them on your tax return as ordinary income. Unlike short-term capital gains, capital losses do not offset short-term capital gains distributions and reduce your tax liability. However, within the mutual fund, short-term gains will be offset by any losses—but these are controlled by the fund manager, not the individual investor.

The Bottom Line

Think of it this way: It might quickly become a problem to the extent that you had planned to reduce your tax bill by using tax-loss harvesting strategies or investing in tax-efficient funds.

If you or your financial advisor believe that short-term capital gains distributions are just like short-term capital gains, then you might be unpleasantly surprised at tax time when you owe more in taxes than you had planned.

The Balance does not provide tax or investment advice or financial services. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.