Capital gains distributions from mutual funds are net capital gains from the sale of shares of securities held by the fund. Unless the fund is held in a tax-deferred account, such as an IRA or 401(k), these distributions are taxable to the fund's shareholders (k).
Definition and Illustration Distributions of Capital Gains from Mutual Funds
Each year around November or December, mutual fund shareholders may receive capital gains distributions from their mutual funds. The fund's managers sold shares of one or more of the fund's holdings during the tax year, which resulted in these distributions. Capital gains may result if the fund manager decides to sell stock due to a changing outlook or if the fund needs to raise cash for shareholder redemptions. If the stock is trading at a higher price than when the fund manager bought it, the fund must distribute at least 95 percent of its gains and taxes to shareholders. These distributions are considered your income because they are paid to you or credited to your mutual fund account. You don't have to sell mutual fund shares to realize a capital gain. When you receive a dividend, interest, or principal payment from the issuer of a stock or bond, this is referred to as a distribution.How Does a Capital Gains Distribution from a Mutual Fund Work?
Let's say XYZ Mutual Fund paid $1 for 100,000 shares of a company 20 years ago. The fund sells the shares for $50 today, netting a long-term capital gain of $49 per share. The gain must be distributed to current shareholders, who must then report it on their individual tax returns. Note: While receiving a capital gains distribution may appear to be a good thing, the distribution has no economic value. If you own 1,000 shares of XYZ Mutual Fund and reinvest all capital gains and dividends, you will have made a profit of $1,000. If the fund's net asset value (NAV) is $10 per share, your investment in the fund equals $10,000. If the fund distributes long-term capital gains, the gain on the sale of stock is equal to 10% of the total net asset value (NAV), or $1 per share. The fund's NAV will be reduced by $1 on the ex-dividend date, and shareholders will receive $1 for each share they own on the record date. As a result, $1,000 will be added to your account. If the fund's market value doesn't change, you'll still own $10,000 of it.Individual Investors: What Does It Mean?
If you have mutual funds in a taxable account, capital gains distributions result in a tax bill, but they have no effect on retirement accounts. When you reinvest your gains, they are added to your cost basis, lowering your taxable gain when you sell the fund. If you have mutual funds in a taxable account, you should focus on funds with low turnover. This category includes index funds, tax-advantaged mutual funds, and even some actively managed funds. To find out if and when capital gains distributions will be made, go to your fund's website at the beginning of October each year. If you expect large distributions, weigh the benefits and drawbacks of owning the fund. Selling the fund might be a good idea if you want to avoid the distribution and the associated tax bill. Keep in mind that if you buy the fund again within 30 days, either in your taxable account or in your IRA, you'll be in violation of the IRS's wash sale rules. When you sell or trade an asset at a loss and then do the following within 30 days of the sale, either after or before the sale:- Invest in securities that are nearly identical.
- In a fully taxable trade, obtain substantially identical securities; and
- Obtain a contract or option to purchase securities that are nearly identical.
- You won't be able to deduct your losses on your tax return if your trades fall under the wash sale rule. To avoid this outcome, think twice before selling your mutual fund shares. You want to make sure that the tax savings from capital gains distributions outweigh the cost of selling your stock.
Important Points to Remember
- Due to market fluctuations or to raise cash, mutual funds frequently sell shares of their holdings late in the year.
- As a result, you may realize a long- or short-term capital gain, triggering tax obligations.
- If you understand the rules, you can sell a fund to avoid paying distributions.
- Distributions from a tax-advantaged account, such as a retirement plan, are not subject to income tax.
Questions and Answers (FAQs)
What happens to capital gains from mutual funds?
Capital gains from mutual funds are usually automatically reinvested into your account.How can I reduce my income taxes by offsetting capital gain mutual fund distributions?
Investing in mutual funds through a retirement account can help you save money on taxes.Tax-loss harvesting can also be used to offset capital gains with capital losses, potentially lowering or eliminating capital gains tax liability.