For investors in a mutual fund, a capital gains distribution occurs when the fund manager sells shares of the fund’s underlying assets – often individual stocks or other securities – at an appreciated value.
It can also happen when the fund receives dividend or interest income (minus the fund’s operating expenses) from the fund’s holdings.
As we will explain later, tax law makes it advantageous for the fund to distribute this income to shareholders rather than keep the money in the fund.
Taxation of Capital Gains Distributions
Capital gains distributions from mutual funds are taxed the same as capital gains for individuals’ portfolios.
Capital gains are classified as either short-term or long-term. If the security sold was held for one year or less, the gain is considered short-term. If the security was held for longer than one year, the gain is long-term. Note that it does not matter how long the investor held the shares, only how long the fund held the shares.
Short-term capital gains distributions are taxed at the investor’s top marginal income tax rate. Long-term distributions are taxed at the capital gains rate, which depends on the investor’s total taxable income. An investor’s long-term rate is lower than their top marginal income tax rate.
Net Investment Income and the Conduit Theory
Capital gains distributions can be taxing – pun intended. But there is a reason why funds distribute their net investment income (dividend and interest income minus fund operating expenses) this way.
As you may know, mutual funds are organized as corporations or trusts. So their earnings are subject to taxation just like any other such entity. This additional level of taxation can really shrink a capital gain distribution to the disadvantage to investors, though.
Consider this example: XYZ Fund owns shares of ABC Corporation. ABC pays taxes on earnings before paying a dividend. XYZ Fund pays taxes on the dividend they receive. Then the individual investor pays tax on the remaining amount. That’s triple taxation.
However, by acting as a “conduit” and distributing at least 90% of its net investment income to shareholders, the fund can avoid tax on the distributed amount. In turn, that means less in taxes for the fund and more earnings passed on to investors.
Capital Gains Distributions in Retirement Accounts
For those who use an individual retirement account (IRA) for retirement planning, the taxation of capital gains distributions is less of a worry.
In an IRA, the taxation of all types of gains is deferred until money is withdrawn from the account. At that time, contributions and gains are combined and are fully taxable at the investor’s ordinary income tax rate. Whether the gains were short-term or long-term is of no consequence.
Funds pay capital gains distributions to IRA investors, but they are held in the account as cash or reinvested as the owner of the account wishes. Either way, they aren’t taxed until withdrawn.
It’s something to think about when deciding on what type of account to use when planning for retirement.
