Capital Gains distribution

Capital gains distribution refers to the distribution of profit obtained by selling the stocks and other securities of the mutual fund. In other words, it is the handing out of capital gain generated by the mutual funds to the investors.

Capital gains and losses result from investment strategies and trading activities implemented by the mutual fund managers. The IRS requires mutual funds to disperse the capital gains to investors. Therefore, the investor must pay capital gain taxes on the profit received, even if it is reinvested in the mutual fund.

• Capital gains distribution refers to the distribution of profit obtained by selling the stocks and other securities of the mutual fund.
• Investors are liable to pay taxes for the distributions received unless they hold an Individual Retirement, 401(k), and 403(b) accounts.
• The distribution decreases the net asset value (NAV) of the fund by the value distributed.
• It is different from mutual fund dividends. A mutual fund's investment earns dividend and interest income, and it must be paid to mutual fund holders at least once per year.

Capital gains distribution from a mutual fund is the aftereffect of selling investments that have increased in value, given that realized gains exceed realized losses. Along with the dividend and interest on investment, it increases investors' income. At the same time, the share price or the net asset value (NAV) of the fund decreases in line with the distribution to shareholders. However, distributions do not affect the total return.

Mutual fund managers undertake the task of buying and selling stocks. It is important to make money for the investors. If the mutual fund holds a capital asset for more than a year, the profit is capital gain, which the mutual fund allocates to investors as a distribution. These are often paid to the investors or credited to their mutual fund account and are treated as income while filing tax returns.

A mutual fund is not liable to pay taxes for the realized net capital gain; the shareholders pay the taxes for it. However, these shareholders must add it to their individual income tax returns and pay tax. Shareholders in tax-sheltered accounts such as individual retirement and 401(k) and 403(b) accounts – are not liable to pay taxes on capital gain received. Ordinary income tax rates are applied for short-term gains, and long-term capital gains distribution tax rates are used for long-term gains.

There are different ways to reduce the tax liability caused by distributions. The common method is to use tax-sheltered or tax-deferred accounts. Another tax-reducing strategy is tax-loss harvesting. It is done by selling specific investments to generate losses and using losses to neutralize the gains. Furthermore, the distribution size generally depends on fund managers' decisions and the fund types. For example, funds like index funds following a passive investment strategy hold stocks for long periods. Hence, they will generate fewer distributions and taxes due to infrequent trade. 

Mr. A owns some shares of ABC Inc. in a mutual fund. The mutual fund sold ABC's stock when it appreciated. Due to the ABC stock sale, Mr. A received his portion of the capital gain and incurred no other capital loss, and he has to pay taxes on the capital gain received.

A mutual fund sold a share for $100. The gain from the sale is $10, and the corresponding distribution amount will be $10. At the same time, the share price will be reduced by the distribution amount. Hence, the price will fall to $90 ($100-$10). 

• The mutual fund capital gains distribution occurs in reaction to the profitable sale of stocks or other securities. A mutual fund dividend is an income earned by the fund from dividends and interest paid by the fund's holdings.
• The mutual fund will mail a year-end account statement in January and a Form 1099-DIV in mid-February to report the dividend and total capital gains distribution details during the tax year.
• Gain distribution occurs annually, generally in December. In contrast, dividends are paid quarterly or annually.
• Generally, a fund manager or investor decides whether to sell the stocks to realize the gains. But on the other hand, companies make dividend decisions.

This has been a Guide to what is capital gains distribution. We explain the total distribution from mutual funds, tax liability, and vs. dividend. You can learn more from the following articles – 

• Capital Gains vs Dividends
• Capital Gains Yield
• Preservation of Capital