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investopedia.com

Understanding Capital
Gains Distribution
By James Chen
4-5 minutes

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. It is the investor's share
of the proceeds from the fund's transactions.
It is not 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

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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.
The capital gains distribution will be identified as
a long-term capital gain or a short-term capital
gain and is taxable as such.
People who really hate paying taxes might
consider tax-efficient funds and other tax-efficient
investments.

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.

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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taxes will be due when the funds are withdrawn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.

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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 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

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gains might be offset or even erased by other

investments that lost money.

Key Takeaways

A capital gains distribution is the investor's share

of the proceeds of a fund's sale of stocks and
other assets.
The investor must pay capital gains taxes on
distributions, whether they are taken as cash or
reinvested in the fund.
The taxes on distributions are due in that tax
year unless the fund is part of a tax-deferred
retirement account.

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

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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.

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