Definition and Example Mutual Fund Capital Gains Distributions
Mutual fundshareholders face the possibility of receiving capital gains distributions from their mutual funds each year around November or December. These distributions are the result of the fund's managers selling shares of one or more of the fund's holdings during the tax 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.
These distributions are paid to you or credited to your mutual fund account, so they are considered your income. You do not have to sell shares of the mutual fund in order to have realized a capital gain.
Note
For stocks or bonds, a distribution occurs when you receive a payment of a dividend, interest, or principal from the issuer of the security.
How Does a Mutual Fund Capital Gains Distribution Work?
Suppose 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 along-term capital gainof $49 per share. The fund must distribute the gain to current shareholders, who must report the gain on their personaltax returns.
Note
It might seem like a good thing to receive a capital gains distribution, but there's actually no positive economic value to the distribution.
Suppose 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 anet asset value(NAV) of $10 per share.
The gain upon the sale of stock is 10% of the fund'stotal net asset value (NAV), or $1 per share, if the fund distributeslong-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 theex-dividend date.
Your account will receive $1,000 as a result. You'll still own $10,000 of the fund, assuming that there's no change in market value.
What It Means for Individual Investors
Capital gains distributions result in a tax bill if you own mutual funds in a taxable account, but they don't impact retirement accounts. The reinvestment of the gains is added to your cost basis, which lowers your taxable gain when the fund is eventually sold.
Note
You might want to focus on low-turnover funds if you own mutual funds in a taxable account. These include index funds,tax-efficient mutual funds, and even someactively managed funds.
Visit your fund company's website at the start of in October of each year to find out whether and when there will be capital gains distributions. Weigh the pros and cons of owning the fund if you expect the distributions to be large. You might want to sell the fund to avoid the distribution and the tax bill that will come with it.
Keep in mind, though, that you'll run afoul ofthe Internal Revenue Service (IRS) wash sale rules if you buy the fund again within 30 days, either in yourtaxable accountor in your IRA. A wash sale happens when you sell or trade an asset at a loss and then, within 30 days either after or before the sale, you do the following:
- Buy substantially identical securities;
- Acquire substantially identical securities in a fully taxable trade; and/or
- Acquire a contract or option to buy substantially identical securities
Key Takeaways
- Mutual funds often sell shares of the fund’s holdings late in the year due to changes in the market or to raise cash.
- You can realize a long- or short-term capital gain as a result, causing taxes to be due.
- You can sell a fund to avoid distributions if you understand the rules.
- Distributions from funds held in a tax-advantaged account, such as a retirement plan, are not taxable.
If your trades fall under the wash sale rule, you won't be able to deduct the losses on your tax return. To prevent this result, think carefully before selling shares in your mutual fund. You want to be sure that avoiding the tax burden from capital gains distributions is worth disposing of your shares.
Frequently Asked Questions (FAQs)
Where do mutual fund capital gains go?
Mutual fund capital gains are usually reinvested into your account for you.
How can I offset capital gains mutual fund distributions to lower my income taxes?
Owning mutual funds through a retirement account will lower your income tax burden. You can also use tax-loss harvesting to offset capital gains with capital losses, which can lower or even eliminate your capital gains tax burden.
