Capital gains can occur if the fund manager decides to sell stock due to the changing outlook, or even if the fund must simply raise cash for shareholder redemptions. The fund must distribute at least 95% of its gains and resulting taxes to shareholders if the stock is trading higher than when the fund manager initially purchased it. These distributions are paid to you or credited to your mutual fund account, so they are considered your income. You do not have to sell shares of the mutual fund in order to have realized a capital gain.
How Does a Mutual Fund Capital Gains Distribution Work?
Suppose XYZ Mutual Fund purchased 100,000 shares of a company 20 years ago for $1. The fund sells the shares today for $50, which results in a long-term capital gain of $49 per share. The fund must distribute the gain to current shareholders, who must report the gain on their personal tax returns. Suppose you own 1,000 shares of XYZ Mutual Fund, and you reinvest all capital gains and dividends. Your investment in the fund equals $10,000 if the fund has a net asset value (NAV) of $10 per share. The gain upon the sale of stock is 10% of the fund’s total net asset value (NAV), or $1 per share, if the fund distributes long-term capital gains. Shareholders will receive $1 for each share they own on the record date, and the NAV of the fund will be reduced by $1 on the ex-dividend date. Your account will receive $1,000 as a result. You’ll still own $10,000 of the fund, assuming that there’s no change in market value.
What It Means for Individual Investors
Capital gains distributions result in a tax bill if you own mutual funds in a taxable account, but they don’t impact retirement accounts. The reinvestment of the gains is added to your cost basis, which lowers your taxable gain when the fund is eventually sold. Visit your fund company’s website at the start of in October of each year to find out whether and when there will be capital gains distributions. Weigh the pros and cons of owning the fund if you expect the distributions to be large. You might want to sell the fund to avoid the distribution and the tax bill that will come with it. Keep in mind, though, that you’ll run afoul of the Internal Revenue Service (IRS) wash sale rules if you buy the fund again within 30 days, either in your taxable account or in your IRA. A wash sale happens when you sell or trade an asset at a loss and then, within 30 days either after or before the sale, you do the following:
Buy substantially identical securities;Acquire substantially identical securities in a fully taxable trade; and/orAcquire a contract or option to buy substantially identical securities
If your trades fall under the wash sale rule, you won’t be able to deduct the losses on your tax return. To prevent this result, think carefully before selling shares in your mutual fund. You want to be sure that avoiding the tax burden from capital gains distributions is worth disposing of your shares.
