What Is a Capital Gains Distribution?
A capital gains distribution is a payment made by a mutual fund or an exchange-traded fund (ETF) representing a portion of the proceeds from the fund’s sales of stocks and other assets from within its portfolio.It’s the investor’s pro-rata share of the proceeds from the fund’s transactions.
It’s not a share of the fund’s overall profit, however. The fund may gain or lose money over a year and your balance will rise or fall accordingly. But the fund will make capital gains distributions to its shareholders if it gained from selling any of its stocks during that year.
Mutual funds are required by law to make regular capital gains distributions to their shareholders. The owners of mutual fund shares have the option to take the capital gains distribution in the form of immediate payments or to reinvest it in additional fund shares.
Key Takeaways
- A capital gains distribution is the investor’s share of the proceeds of a fund’s sale of stocks and other assets.
- The investor must pay capital gains taxes on distributions whether they’re taken as cash or reinvested in the fund.
- The taxes on distributions are due in that tax year unless the fund is part of a tax-deferred retirement account.
- Capital gains distributions from mutual fund or ETF holdings are taxed as long-term capital gains under Internal Revenue Service (IRS) regulations. This is the case no matter how long the individual has owned shares of the fund.
- Capital gains distributions from pooled investments are treated as long-term capital gains, but buying and selling fund or ETF shares with a holding period of one year or less results in an event that the IRS treats as regular income.
Understanding Capital Gains Distributions
A mutual fund or ETF generally distributes capital gains at the end of each year. The distribution represents the proceeds of the sales of stock or other assets by the fund’s managers throughout the tax year.
Cashing in on the capital gains distribution rather than reinvesting it in the fund is effectively a withdrawal. It reduces the net amount you’ve invested in the fund by the distribution amount.
Reinvesting Capital Gains
Reinvesting capital gains involves using the profits from selling an asset to purchase more assets. Doing so can affect the timing and amount of taxes owed.
Reinvesting capital gains doesn’t eliminate tax liability but can impact the timing and amount of taxes owed.The tax rate depends on how long the original asset was held and the investor’s income.If capital gains are reinvested in a tax-advantaged account, like an individual retirement account (IRA) or 401(k), the gains may grow tax-deferred until withdrawal.
When capital gains are reinvested, the distribution is added to the cost basis, which increases the number of shares owned and the cost basis for those shares.
One option is to reinvest capital gains into a rental or investment property. A 1031 exchange can be used to roll the proceeds from the sale of that property into a like investment within 180 days.
Tax Considerations of Capital Gains Distributions
Mutual fund share owners are required to pay taxes on capital gains distributions made by the funds they own regardless of whether the money is reinvested in additional shares. There’s an exception for municipal bond funds, however, which are tax-exempt at the federal level and usually at the state level.
The taxes aren’t due for that tax year if the investor owns the fund as part of an IRA, 401(k), or other tax-deferred retirement plan. They’ll come due when the funds are withdrawn in retirement.
The taxes are due for that tax reporting period if the fund isn’t a retirement plan.
Capital gains distributions from pooled investments are treated as long-term capital gains, but you can buy and sell fund or ETF shares with a holding period of one year or less and this would result in short-term capital gains or losses for those shares. Short-term capital gains are taxed along with your other income according to your marginal tax bracket. Capital gains distributions are different from the actual holding period of the fund shares.
Current IRS Regulations
Capital gains distributions from mutual fund or ETF holdings are taxed as long-term capital gains under IRS regulations no matter how long the individual has owned shares of the fund. The long-term capital gains tax rate is 0%, 15%, or 20%, depending on the individual’s overall taxable ordinary income.
You might consider tax-efficient investments, including tax-efficient funds if you really hate paying taxes. Tax-efficient funds identify themselves as such in their descriptions. They tend to buy and sell stocks less frequently than aggressive growth funds and may hold some municipal bond funds for tax-free income.
Capital gains distributions can be made even when a fund’s overall value has dropped during the year. A fund may have sold some appreciated stocks, but these gains might be offset or even erased by other investments that lost money.
Capital Gains Distributions and Net Asset Value
The distribution of capital gains and dividends decreases a fund’s net asset value (NAV) by the amount distributed. A fund manager with a net asset value of $20 per share might pay a $5 distribution to shareholders. This would result in the fund’s net asset value declining by $5 to $15 per share.
This appears on a mutual fund’s price chart as a decline in price on the ex-dividend date, but the fund’s total return hasn’t changed. Unrealized gains on securities determinethe mutual fund’s net asset value until they’re sold.
How Are Capital Gains Distributions Taxed?
Holders of mutual fund shares are required to pay taxes on capital gains distributions made by the funds they own. Capital gains distributions from mutual fund or ETF holdings are taxed as long-term capital gains regardless of how long the taxpayer has owned shares of the fund. The long-term capital gains tax rate is 0%, 15%, or 20%, depending on the individual’s overall taxable income.
Where Can I Report Capital Gain Distributions on a Form 1040 Tax Return?
Taxpayers should report capital gains distributions on line 13 ofSchedule D (Form 1040), Capital Gains and Losses, according to the IRS.
What Is the Difference Between a Capital Gains Distribution and a Capital Gain?
Capital gains are anyincrease in a capital asset’s value. Capital gains distributions are payments that a mutual fund or an exchange-traded fund (ETF) makes to its holders that are a portion of proceeds from the fund’s sales of stocks or other portfolio assets.
The Bottom Line
Investing in mutual or exchange-traded funds means you might receive a capital gains distribution regardless of whether you sold any shares. Be prepared to pay taxes on any capital gains distributions you receive.
