Taxation is a complex topic to understand. But the taxation of mutual fund short-term capital gains is one of the least understood topics when it comes to investing. Many people know about short-term capital gains. But understanding short-term capital gains distributions of mutual funds can be much more difficult.
Here's what you should know about how mutual fund short-term capital gains are distributed.
- Mutual fund shareholders can expect to receive capital gains distributions once a year; most often, this is done in a lump sum at year’s end.
- You’ll realize short-term capital gains if you hold the shares for one year or less. They will be taxable at your ordinary income tax rate.
- You’ll realize long-term gains if you hold the shares for more than a year. This tax rate can be more favorable.
What Are Mutual Fund Capital Gains Distributions?
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 most often 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 paying taxes on these distributions—at least temporarily. This can be done 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." They will be distributed to shareholders as short-term capital gains. These are taxed at the same rate as ordinary income.
What if a mutual fund sells shares that it has owned for more than 12 months? In that case, any gains as a result of the sale are classified as "long-term capital gains." They will be distributed as long-term capital gains. Long-term capital gains are subject to long-term capital gains taxes. These are more favorable than ordinary income tax rates.
Shareholders may face both long-term and short-term capital gains distributions. This is a result of owning shares in a particular mutual fund. It doesn't matter 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. It's not about 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 you. For instance, let's say you own a mutual fund for a few months and then sell it for a gain. In that case, you have incurred a short-term capital gain. What if the fund was held in a taxable account? If you don't have enough losses to offset this gain, the net result is a short-term gain. You will have to pay ordinary income tax rates on the amount of money you made as a result of the sale.
In the above scenario, 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. 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. But within the mutual fund, short-term gains will be offset by any losses. These are controlled by the fund manager, not the individual investor.
The Bottom Line
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.