A capital gain distribution is a payment from a mutual fund or an exchange-traded fund (ETF) of proceeds from the fund's sale of stocks or other assets. The allocation to the individual investor represents the taxpayer's share of the profits from the transaction. A capital gain distribution is not the same as the investor's share of the mutual fund's yield. The profits from the dividends paid by the companies in which the fund holds stock are paid to investors as ordinary dividends, and these are taxable income to the individual investor at their ordinary-income rate. Payment of dividends is determined by a company's board of directors and may be related to the company's profit level but is not always a direct measure of profitability. Mutual fund investors also earn a share of the interest payments and asset appreciation enjoyed by the mutual fund, and these profits of the fund’s operation are taxed as ordinary income.
As with the purchase of individual equities, bonds, and other securities, investors buy mutual funds with different goals. Often, investors will choose mutual funds as a way to benefit from the investment expertise of fund managers, diversify their personal portfolios, and reduce risk. Also, buying a mutual fund allows the individual investor to relinquish active decision-making concerning the respective transactions.
A distribution from the sale of a stock that results in a profit to the fund is taxable at the capital gains rate. By law, mutual funds must distribute gains from stock transactions to their shareholders. The fund owners can usually choose whether to take the distribution in immediate payment or reinvest the profit in additional fund shares. That choice does not change the taxable nature of the distribution. If the mutual fund shareholder reinvests the distribution back into the fund, the amount is still reportable as a capital gain.
However, the good news for shareholders is that if the gain is a qualified capital gain, the IRS guidance allows the taxpayer to consider the payment as a long-term capital gain without regard to the length of time they have held the mutual fund shares. This stance means that if you have owned the shares for less than a year, you can still use the more favorable long-term capital gains tax rate when calculating the taxable impact.
Keep in mind that almost all municipal bond funds are tax-exempt at the federal level and often at the state level. This knowledge is essential when considering the basics of asset location, which is a strategy for optimizing the best account in which to keep different investments. Suppose you contribute to tax-deferred accounts, such as an IRA (Individual Retirement Account) or a 401(k) deferred retirement savings account. In that case, you can enjoy the benefits of capital or other gains in those accounts without paying taxes until you are in the withdrawal stage. The assumption is that your tax rate will likely be lower when you withdraw from those accounts than when you are contributing to them. So one approach to tax management is to keep the funds that emphasize gains in the tax-deferred accounts and focus your taxable brokerage or other accounts on funds that are exempt (like bonds) or generate less dividend income.