Previous Realized blogs have outlined capital gains, what they are, and how they’re taxed. Then there are capital gains distributions. In concept, these are similar to capital gains, in that both are defined as profit generated from the sale of capital assets. They differ, however, in that capital gains distributions arise from investments in mutual funds and exchange-traded funds.
There can be many benefits when it comes to mutual fund investments. It also pays to be aware that profits generated from these investments funds are taxable, whether you accept the disbursements, or reinvest them into other funds.
What They Are
To understand the concept of capital gains distribution, it’s a good idea to understand the nature of mutual funds and exchange-traded funds, what they are, and how they operate.
A mutual fund is an investment vehicle that combines money from different individuals and entities. With those monies in hand, the fund sets about building portfolios of equities, bonds, and other securities. Exchange-traded funds, in the meantime, track commodities, sectors, or indexes, but can be purchased or sold on stock exchanges, similar to corporate stocks.
These funds can offer the following benefits:
- They provide access to professionally managed portfolios, which are generally under the direction of skilled managers or sponsors.
- They can assist with portfolio diversity.
- Funds can match investors’ risk appetites and/or tolerance.
- They are generally liquid; investors can redeem fund shares at any time for the current net asset value, plus any redemption fees.
Investors earn money from mutual funds in the following ways:
- Dividends on stock or interest on bonds. When this happens, the fund pays investors most of the income, less expenses.
- Capital gains distributions. When the fund sells a security at a profit, this leads to a capital gain. By law, that fund is required to distribute capital gains (minus any losses) to investors.
It’s important to understand that both dividends and capital gains distributions will be taxed. The latter, in fact, is taxed, whether you actually sell shares of the fund or not.
How They Are Taxed
While it might not seem fair that you’re taxed on capital gains distributions even if you don’t sell your mutual fund shares, the IRS doesn’t necessarily see it that way. The IRS notes that, you, the investor, don’t have direct ownership of the capital asset, or assets, in question. Rather you own shares of the entity (i.e., the fund) that owns those capital assets. If the fund in which you own shares sells those stocks, bonds, or securities, capital gains result. You receive capital gains distributions at the end of the year. And you’re responsible for reporting that profit, even if you don’t see it, or you decide to reinvest it in another fund.
On the positive side, the capital gains distributions are taxed similar to long-term capital gains, no matter how long you hold the shares. Most investors might pay a 15% capital gains tax, rather than the potentially higher ordinary income tax rate.
Other ways in which you could mitigate a potential tax burden from capital gains distribution can include the following.
Find mutual funds with a focus on municipal bonds. Such funds are tax-exempt at the federal level (and many times at the state level). This can help reduce taxes owed.
Contribute to tax-deferred accounts, such as an IRA or 401(k). You won’t owe taxes on any capital gains in these accounts, at least until you withdraw funds.
There can be many benefits when it comes to putting money into mutual fund investments. But it’s a good idea to understand the tax issues involved with these types of assets before making the move to invest. Be sure to talk with your tax professional or financial advisor for a clear-eyed view of what you can expect when it comes to working with a mutual or exchange-traded fund.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice, meeting the particular investment needs of any investor. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.