Capital Gains distribution

Updated on April 16, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What is Capital Gains Distribution?

Capital gains distribution refers to the distribution of profit obtained by selling the stocks and other securities of the mutual fund. In other words, it is the handing out of capital gain generated by the mutual funds to the investors.

Capital gains and losses result from investment strategies and trading activities implemented by the mutual fund managers. The IRS requires mutual funds to disperse the capital gainsCapital GainsCapital gain refers to the profit resulting from selling a capital asset or investment at a price higher than its purchase price.read more to investors. Therefore, the investor must pay capital gain taxes on the profit received, even if it is reinvested in the mutual fund.

Key Takeaways

  • Capital gains distribution refers to the distribution of profit obtained by selling the stocks and other securities of the mutual fund.
  • Investors are liable to pay taxes for the distributions received unless they hold an Individual Retirement, 401(k), and 403(b) accounts.
  • The distribution decreases the net asset value (NAV) of the fund by the value distributed.
  • It is different from mutual fund dividends. A mutual fund’s investment earns dividend and interest income, and it must be paid to mutual fund holders at least once per year.

Capital Gains Distribution Explained

Capital gains distribution from a mutual fundMutual FundA mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etcread more is the aftereffect of selling investments that have increased in value, given that realized gainsRealized GainsWhen an asset is sold for a higher price than when it was purchased, it is referred to as a realized gain. Because the seller gains from the transaction, this gain is taxed, however an unrealized gain is not taxable because it is valued at fair market value.read more exceed realized losses. Along with the dividend and interest on investment, it increases investors’ income. At the same time, the share price or the net asset valueNet Asset ValueNet Asset Value (NAV) refers to the net value of an entity or equity obtained by subtracting the total value of its assets from the total value of its liabilities. It also indicates the per share or unit market value of securities like mutual funds, exchange-traded funds (ETFs), indexes, etc., on a given day.read more (NAV) of the fund decreases in line with the distribution to shareholders. However, distributions do not affect the total return.

Capital Gain Distribution

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Source: Capital Gains distribution (wallstreetmojo.com)

Mutual fund managersFund ManagersA fund manager refers to an investment professional responsible for fund investment strategy formulation and implementation. They collect and invest the money from various investors and create a good variety of managed funds catering to the diverse preferences exhibited by the investors. read more undertake the task of buying and selling stocks. It is important to make money for the investors. If the mutual fund holds a capital asset for more than a year, the profit is capital gain, which the mutual fund allocates to investors as a distribution. These are often paid to the investors or credited to their mutual fund account and are treated as income while filing tax returns.

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A mutual fundMutual FundA mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etcread more is not liable to pay taxes for the realized net capital gain; the shareholders pay the taxes for it. However, these shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares.read more must add it to their individual income tax returns and pay tax. Shareholders in tax-sheltered accounts such as individual retirement and 401(k) and 403(b) accounts – are not liable to pay taxes on capital gain received. Ordinary income tax rates are applied for short-term gains, and long-term capital gains distribution tax rates are used for long-term gains.

There are different ways to reduce the tax liabilityTax LiabilityTax liability refers to the outstanding amount to be paid by an individual or company to the government. read more caused by distributions. The common method is to use tax-sheltered or tax-deferred accounts. Another tax-reducing strategy is tax-loss harvestingTax-loss HarvestingTax loss harvesting is a popular strategy wherein the loss-making securities are sold to reduce the tax liabilities arising from the gains made in the other securities. This is to offset capital gains against capital losses by selling those investments having unrealized losses, thereby reducing tax liability.read more. It is done by selling specific investmentsInvestmentsInvestments are typically assets bought at present with the expectation of higher returns in the future. Its consumption is foregone now for benefits that investors can reap from it later.read more to generate losses and using losses to neutralize the gains. Furthermore, the distribution size generally depends on fund managers’ decisions and the fund types. For example, funds like index funds following a passive investmentPassive InvestmentPassive investing is a strategy used by investors to maximize their returns by avoiding frequent portfolio churning by buying and selling securities and instead buying and holding a diverse range of securities.read more strategy hold stocks for long periods. Hence, they will generate fewer distributions and taxes due to infrequent trade. 

Video: Capital Gains vs. Dividends

 

Examples

Mr. A owns some shares of ABC Inc. in a mutual fund. The mutual fund sold ABC’s stock when it appreciated. Due to the ABC stock sale, Mr. A received his portion of the capital gainCapital GainCapital gain refers to the profit resulting from selling a capital asset or investment at a price higher than its purchase price.read more and incurred no other capital lossCapital LossCapital Loss is a loss when the value of the consideration received from the result of the transfer of capital assets is less than the aggregate value of the cost of acquisition & cost of the improvement. In simpler words, it can be stated as the loss derived from the transfer of capital assets.read more, and he has to pay taxes on the capital gain received.

A mutual fund sold a share for $100. The gain from the sale is $10, and the corresponding distribution amount will be $10. At the same time, the share price will be reduced by the distribution amount. Hence, the price will fall to $90 ($100-$10). 

Capital Gains Distribution vs. Dividends

  • The mutual fund capital gains distribution occurs in reaction to the profitable sale of stocks or other securities. A mutual fund dividend is an income earned by the fund from dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more and interest paid by the fund’s holdings.
  • The mutual fund will mail a year-end account statement in January and a Form 1099-DIV in mid-February to report the dividend and total capital gains distribution details during the tax year.
  • Gain distribution occurs annually, generally in December. In contrast, dividends are paid quarterly or annually.
  • Generally, a fund manager or investor decides whether to sell the stocks to realize the gains. But on the other hand, companies make dividend decisions.

Frequently Asked Questions (FAQs)

How are capital gains distribution taxed?

The capital gain is provided to the fund investors annually when the realized capital gain exceeds the realized capital losses. Therefore, the income increase may bring a sudden tax hit on a shareholder and disrupt the savings. Also, ordinary income tax rates are applied for short-term gains, and long-term capital gain tax rates are used for long-term gains. However, the distributions are not taxed if a shareholder has an Individual Retirement, 401(k), and 403(b) accounts.

Are capital gains distribution considered income?

Yes, it is treated as income. The distributions are normally paid to investors or credited to an investor’s mutual fund account. Investors can generally reinvest the mutual fund gains to add more shares.

Are capital gains distributions a good thing?

It is a good thing if the investors have the opportunities to reduce their tax liabilities by using tax-sheltered accounts and strategies like tax-loss harvesting.

This has been a Guide to what is capital gains distribution. We explain the total distribution from mutual funds, tax liability, and vs. dividend. You can learn more from the following articles – 

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