Capital Gains Distribution: What It Is and How It's Taxed

What Is a Capital Gains Distribution?

A capital gains distribution is a payment made by a mutual fund or an exchange-traded fund (ETF) representing a portion of the proceeds from the fund's sales of stocks and other assets from within its portfolio. It's the investor's pro-rata share of the proceeds from the fund's transactions.

It's not a share of the fund's overall profit, however. The fund may gain or lose money over a year and your balance will rise or fall accordingly. But the fund will make capital gains distributions to its shareholders if it gained from selling any of its stocks during that year.

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.

Understanding Capital Gains Distributions

A mutual fund or ETF generally distributes capital gains 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 tax year.

Cashing in on the capital gains distribution rather than reinvesting it in the fund is effectively a withdrawal. It reduces the net amount you've invested in the fund by the distribution amount.

Tax Considerations of Capital Gains Distributions

Mutual fund share owners are required to pay taxes on capital gains distributions made by the funds they own regardless of whether the money is reinvested in additional shares. There's an exception for municipal bond funds, however, which are tax-exempt at the federal level and usually at the state level as well.

The taxes aren't due for that tax year if the investor owns the fund as part of an IRA, 401(k), or other tax-deferred retirement plan. They'll come due when the funds are withdrawn in retirement.

The taxes are due for that tax reporting period if the fund isn't a retirement plan.

Current IRS Regulations

Capital gains distributions from mutual fund or ETF holdings are taxed as long-term capital gains under IRS regulations no matter how long the individual has owned shares of the fund. The long-term capital gains tax rate is 0%, 15%, or 20%, depending on the individual's overall taxable ordinary income.

You might consider tax-efficient investments, including tax-efficient funds if you really hate paying taxes. 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 can be made even when a fund's overall value has dropped during the year. A fund may have sold some appreciated stocks but these gains might be offset or even erased by other investments that lost money.

Capital Gains Distributions and Net Asset Value

The distribution of capital gains and dividends decreases a fund's net asset value (NAV) by the amount distributed. A fund manager with a net asset value of $20 per share might pay a $5 distribution to shareholders. This would result in the fund's net asset value declining by $5 to $15.

This appears on a mutual fund's price chart as a decline in price on the ex-dividend date but the fund's total return hasn't changed. Unrealized gains on securities determine the mutual fund's net asset value until they're sold.

The Bottom Line

Investing in mutual or exchange-traded funds means you might receive a capital gains distribution regardless of whether you sold any shares. Be prepared to pay taxes on any capital gains distributions you receive.