How Mutual Fund Capital Gains Distributions Work
Mutual funds often sell profitable investments at certain times throughout the year. The funds then distribute the profits to shareholders in the form of capital gains distributions. Capital gains distributions are reported on Form 1099-DIV, which shows dividends and capital gains distributions paid throughout the year. They’re taxed at long-term capital gains tax rates regardless of how long you own the shares within the fund. Capital gains distributions can be reported directly on Form 1040 if you have no other capital gains to report. Otherwise, they’re reported on Schedule D along with your other gains and losses.
Accounting For Capital Gains Distribution
When it comes to calculating your capital gain or loss, you need to do so for each mutual fund share you sell. That is where it gets complicated, because you’ll have a different cost basis and a different holding period for each share if you’ve invested in the fund over a period of time. The IRS lets you choose one of three different accounting methods to calculate your gain. You might want to calculate all three methods in a trial run to determine which is the most advantageous for you. The allowable accounting methods are:
Actual cost basis using specific identificationActual cost basis using first-in, first-out identificationAverage cost basis, single-category method
Using Specific Identification
The specific identification method of accounting is the preferred method for savvy investors, but it requires ongoing attention to detail. You’ll have to keep track of each lot of shares you buy and sell, and your broker must allow you to sell specific shares. This option is usually provided within a mutual fund company’s cost basis tracking service. Specific identification lets you choose which shares to sell for the greatest possible tax benefit. An investor might want to sell the most profitable shares to offset other losses, or they might want to sell the least profitable shares to minimize capital gains tax.
Using First-In, First-Out Identification
You can still use the actual-cost-basis method even if you can’t specify particular shares to sell. You would keep track of your cost basis for every lot of shares you buy, and assume that the first shares sold were the first shares you bought.
Single-Category or Average Cost Method
You can calculate your average cost basis according to the price you paid for each share by using this method, including any reinvested dividends and reinvested capital gains. The average cost basis is the total purchase price of all shares, divided by the number of shares you owned at the time. When you sell some shares, it’s assumed that they’re sold on a first-in, first-out basis. Your capital gain is calculated using the holding period of the oldest shares being sold, even if you’re selling a mixture of long-term and short-term shares.
Reinvested Dividends and Capital Gains Distributions
Many investors reinvest dividends and capital gains distributions received from their mutual funds. Each reinvestment counts as both a cash distribution and an additional fund purchase. The dividends and capital gains distributions are included in taxable income. For example, you invested $1,000 in a non-dividend paying mutual fund. XYZ After one year, due to increase in the markets your investments in XYZ increased to $1,500. Since you invested $1,000 and got no dividends your cost basis for XYZ is $1,000. Based on that, your capital gain is $500 ($1,500-$1,000) on which you will pay capital gains tax. Now, consider a scenario where you invested that $1,000 in a dividend paying fund ABC instead and during the year the fund paid out $500 in dividends and you reinvested that dividend money to buy more shares in ABC. Your year-end investment will still be worth $1,500 but your cost basis for ABC will increase to $1,500 because the dividend was used to purchase more shares in the fund and will be treated like an investment.
