Capital Gains Distribution: What It Is, How It's Taxed

What Is a Capital Gains Distribution?

A capital gains distribution is a payment by a mutual fund or an exchange-traded fund (ETF) of a portion of the proceeds from the fund's sales of stocks and other assets from within its portfolio. It is the investor's pro-rata share of the proceeds from the fund's transactions.

It is not, however, a share of the fund's overall profit. The fund may gain or lose money over the course of a year, and your balance will rise or fall accordingly. But if the fund gained from the sale of any of its stocks during that year, it will make capital gains distributions to its shareholders.

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.

Understanding Capital Gains Distributions

Generally, a mutual fund or ETF makes a capital gains distribution 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 course of the tax year.

The investor should keep in mind that cashing in on the capital gains distribution rather than reinvesting it in the fund is effectively a withdrawal. It reduces the net amount you have invested in the fund by the amount of the distribution.

Tax Considerations of Capital Gains Distributions

Holders of mutual fund shares are required to pay taxes on capital gains distributions made by the funds they own, whether or not the money is reinvested in additional shares. There is an exception for municipal bond funds, which are tax-exempt at the federal level and usually at the state level.

The taxes are not due for that tax year if the investor owns the fund as part of an IRA, 401(k), or another tax-deferred retirement plan. The taxes will be due when the funds are withdrawn after retirement.

If the fund is not in a retirement plan, the taxes are due for that tax reporting period.

Current IRS Regulations

Under current IRS regulations, capital gains distributions from mutual fund or ETF holdings are taxed as long-term capital gains, no matter how long the individual has owned shares of the fund. That means a tax rate of 0%, 15%, or 20%, depending on the individual's ordinary income tax rate.

People who really hate paying taxes might consider looking at tax-efficient investments, including tax-efficient funds. 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 may be made even when a fund's overall value has dropped during the year. That is, a fund may have sold some stocks that had appreciated in price, but these gains might be offset or even erased by other investments that lost money.

Capital Gains Distributions and Net Asset Value

As is the case with common stocks, the distribution of capital gains and dividends decreases the net asset value (NAV) of the fund by the amount distributed. For instance, the fund manager of a fund with a net asset value of $20 per share may pay a $5 distribution to shareholders. This would result in the fund's net asset value declining by $5 to $15.

Although this appears on a mutual fund's price chart as a decline in price on the ex-dividend date, the total return of the fund has not changed. Unrealized gains on securities determine the mutual fund's net asset value until they are sold.