Capital Gains Distributions
Mutual fund capital gains distributions are often misunderstood and can be an unpleasant surprise for investors with taxable accounts. No investor sets out to pay more taxes than necessary when selecting mutual funds. However, capital gains distributions can catch you off guard if you are not familiar with what they are and how they work. It is important to educate yourself now about capital gains distributions and how they might affect your tax bill every April.
Each year, generally in November and December, mutual fund shareholders face the possibility of receiving capital gains distributions. These capital gains distributions are the result of fund managers selling shares of underlying holdings within the fund during the taxable year. If the fund manager decides to sell a stock that has appreciated in price, the fund manager must distribute the gains to mutual fund shareholders. The distribution is taxable to the fund shareholders unless the fund is held in a qualified account (IRA, 401(k), etc.).
For example: ABC mutual fund purchased one share of stock 25 years ago for $1. Today the position is worth $50. This results in a long‐term capital gain of $49. When the fund sells the underlying stock, the fund must distribute the gains to current shareholders and the shareholders must report the gain on their personal tax return. These gains are treated as either short‐ or long‐term capital gains, so any short‐term capital gains will be taxed as ordinary income rates while long‐term gains receive preferential tax treatment.
Investors typically focus on maximizing their returns, and rightfully so. However, focusing on return and ignoring other factors, in this case potential capital gains distribution tax, can have the effect of lowering your total after‐tax return. If you own mutual funds in a taxable account, you may want to focus on low‐turnover funds, which include index funds and tax‐efficient mutual funds. Savant utilizes low‐turnover, tax‐efficient mutual funds that are designed to avoid unnecessary taxes. By doing this, investors are able to keep more of their return instead of paying it back to the government in April.
This is intended for informational purposes only and should not be construed as legal, investment or financial advice. Please consult your legal, investment and financial professionals regarding your specific circumstances.