Summary - A capital gains distribution is a taxable event that is triggered by tax laws that mandate mutual fund and exchange-traded fund (ETF) managers must payout at least 95% of the fund’s investment income and capital gains to shareholders. For shareholders in a fund that is not tax deferred this will mean they have to pay a tax on this distribution in the current tax year. The amount of the tax depends on how the gain is categorized.
A long-term capital gain is realized when the fund has held an asset for longer than 12 months. As of 2018, the long-term capital gains rates were 0, 15, or 20 percent for most taxpayers. A short-term capital gain is realized when the fund has held an asset for less than a year. These gains are taxed as ordinary income which, as of 2018, could be as high as 37%.
Investors who are concerned about their tax liability should check with their fund around October of the current tax year. This is typically the time when companies announce when and how much of a capital gains distribution they will issue.
Introduction
The saying that the only two certainties in life are death and taxes is very true for owners of mutual funds. Mutual funds have become one of the most popular options for investors of all income levels and they are unique in the way they have opened up the opportunity for virtually all wage earners to build wealth for retirement through company-sponsored individual retirement accounts.
However, one caveat for mutual fund owners is the capital gains distribution requirement. Every fund, no matter the size or type, must payout at least 95% of its investment income and capital gains to its shareholders. These shareholders in turn are required to pay a capital gains tax on this distribution. Prior to the 1986 Tax Reform Act, investors were taxed at the long-term capital gains tax rate. Since the passage of that law, capital gains distributions are taxed at two levels, a long-term capital gains tax rate for assets that have been in the fund for over a year and a short-term capital gains rate (which is equal to an investor’s ordinary income tax rate) for funds that have been in the fund for longer than a year. Continue reading to learn more about what capital gains distributions are and how they can affect an investment portfolio.
What is a capital gains distribution?
A capital gains distribution is a payment to shareholders of a mutual fund that is the result of a liquidation of either the underlying stocks and securities or the dividend and interest earned by the fund’s holdings. The capital gains distribution is made by a fund manager due to tax laws that require at least 95% of the investment income and capital gains of a fund to be paid to holders of record. The capital gains distribution is a one-time event. Like a dividend payment, there is a date of record which is when a company recognizes those investors who are considered shareholders of record. There is also an ex-dividend date which is the date at which an investor must be listed as the holder of record to be liable for the capital gains distribution. Since trades in mutual funds follow the +2 Settlement Date, investors need to ensure they have purchased the shares at least two days prior to the ex-dividend date to be considered a holder of record. In a similar way, shareholders who are looking to get out of the fund – and therefore not be subject to the related capital gains tax – must be sure to exit the fund prior to the ex-dividend date so their name will be removed as a holder of record.
Capital gains distribution example
John owns 2000 shares of a mutual fund that has a net asset value (NAV) of $20 per share. This means John’s total investment is worth $40,000 (200 x 20). John has his account setup to reinvest all capital gains and ordinary dividends.
If the fund realizes a capital gain equal to 10% of its NAV, it would mean the capital gains distribution would be $2 per share. Since John owns 200 shares he will receive $2 per share on the ex-dividend date. However, the NAV of the fund will be reduced by $2 on the ex-dividend date.
The result is John receives $4,000 (2000 x 2) which goes to buy additional shares which are now worth $18 per share. This means John’s total number of shares is 2222.22 and his investment is still worth $40,000.
However, if John owns a fund that does not enjoy the benefit of tax-deferred growth, he will be required to pay tax on the capital gain. In this case, his tax liability will be based on $4,000. Let’s say the capital gain is divided evenly where 50 percent is counted as a long-term capital gain and 50 percent as a short-term capital gain.
If John is in the highest tax bracket his long-term tax liability would be $400 ($2,000 x .2). However his long-term liability would be $740 giving him a total tax liability of $1,140.
Why would an investor elect to forfeit a capital gains distribution?
Investors may seek to sell their shares in a mutual fund prior to the capital gains distribution date to lower their tax liability. To better explain this, there are a couple of key points regarding capital gains distributions.
First, capital gains distributions lower the fund’s net asset value (NAV). The formula used for NAV calculation is:
Total value of fund assets – total value of fund liabilities/total number of fund shares outstanding
The NAV dictates the number of shares you can purchase. For example, if a company has a NAV of $100, a purchase of $10,000 would give an investor exactly 100 shares.
Let’s take this one step further. To keep the math simple, let’s make a few additional assumptions:
- Over a year before the investor became a shareholder, the fund manager purchased the stock of a biotech company that was selling at $25 per share. That underlying stock is now paying $75 per share.
- The fund has no offsetting losses and will be realizing the full $50 capital gain.
- The fund currently holds one million shares of the biotech company which means that each share of the mutual fund the investor own also include one share of the biotech company.
- The fund chooses to realize this gain. If the fund did not have any offsetting losses, the gain would be passed to investors as a capital gains distribution. An important point to keep in mind is that capital gains are always netted against losses.
Once the fund realizes the capital gains (i.e. the shares are sold), the fund’s net asset value is cut in half from $100 to $50.
The investor who bought into the fund for $10,000 would now be faced with a taxable gain of $5,000 ($50 per share * 100 shares) and 100 shares of a fund that is now trading at $50 per share meaning their 100 shares are now worth $5,000. But there’s still the matter of the capital gain to reconcile.
If the investor falls into the top tax rate of 39.6%, they will have a tax liability of 20% on this long-term capital gain. In this case, it would be $5,000 x .20 = $1,000.
This leaves the investor with shares that are valued at $5,000 plus a capital gain (after taxes) of $4,000 meaning their initial $10,000 investment is worth $9,000 which means they have a total return of -10%.
What happens when there is a reinvestment of capital gains distributions?
Capital gains distributions can be, and in most cases are, automatically reinvested into the fund. This is convenient and it can help offset the decrease in net asset value. Using our example above, if the investor chooses to reinvest their capital gains distribution, their taxable gain of $5,000 would be used to purchase additional shares at $50 per share. This would now give the owner of the fund and additional 100 shares for a total position of 200 shares. These shares would now be valued at $10,000. However, the investor would still be faced with the $1,000 tax bill for the $5,000 distribution.
Can a fund have a capital loss?
Net capital gains are determined on the net returns of the individual underlying stocks. Which means it is possible it is possible for a fund to have a capital loss. If this is the case, an investor can match up the gains and losses to determine their “net” capital loss. As of this writing, an investor can use up to $3,000 per year of their net loss as an offset against their taxable income on their current year’s income tax return. Furthermore, investors may carry forward any additional losses to subsequent years as either an offset to capital gains or to reduce ordinary income.
How are capital gains distributions different for tax-deferred account?
For investors who have a retirement account, such as a Roth IRA, one of the most important benefits is the ability to defer taxes on capital gains. It doesn’t matter whether the gain is categorized as a long-term gain or a short-term gain, there will be no tax assessed until the investor withdraws money from the fund. However, once an investor begins to withdraw money from the fund, the gains will be taxed as ordinary income. This is typically higher than the more favorable long-term capital gains rate. Because of their tax-deferred status, investors in a tax-deferred mutual fund cannot use a capital loss to offset ordinary income.
How to avoid capital gains distributions in an account that is not tax-deferred
As we just mentioned, one way to postpone the effects of capital gains distributions is to have the funds in an individual retirement account (IRA). This will not remove the tax liability, but it will allow investors to “kick the can” down the road and allow them to pay the tax when they start to withdraw money from the fund.
However, for mutual funds that do not have the tax-deferred benefit, they should contact the fund around the beginning of October. This is typically when funds will announce when, and how much, their capital gains distribution will be. Knowing this information will give investors ample time, if necessary, to pull their money out of the fund. In general, however, it is best to not buy into a mutual fund at the end of the year since you may face a capital gains tax without being able to benefit from the growth of the underlying securities.
The tax implications that result from the sale of securities are different for every investor. In many cases, getting investment and tax advice from your tax professional or even the portfolio manager for a particular fund may be helpful to understand how a capital gains distribution will impact a particular investor’s tax situation.
The final word on capital gains distributions
A capital gains distribution can be a confusing and misleading term for investors. On the one hand, capital gains are generally perceived as a good sign that an investing is appreciating in value. However, a capital gains distribution is a taxable event, which means that investors will have to pay taxes on this distribution. This tax will have to be paid for the current tax year unless the funds are in a tax-deferred account such as an IRA or 401(k).
The amount of tax that an investor will owe on a capital gains distribution will depend on its category. Long-term distributions (for assets held in the fund for longer than a year) are taxed at a more favorable rate than short-term distributions. For some investors, the overall benefit of staying in the fund may outweigh the tax burden. However, many investors will look to lower their tax liability by selling their shares of a mutual fund before the capital gains distribution is realized. Since the capital gains distribution is similar to a dividend payment, there is an ex-dividend date and a date of record to establish and confirm ownership in the fund.
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