Mutual fund capital gain distributions in your brokerage account

If you own a mutual fund in a normal taxable brokerage account (not a “qualified” account like an IRA, Roth IRA or Health Savings Account), you may notice you get potentially large taxable income reported on your 1099, even though you most likely don’t actually get any cash distributed out to you. This is due to capital gain distributions.

When you own shares of a stock in a normal brokerage account, you have to pay tax on any realized gains you have. A realized gain is when you sell the stock for more than what you paid for it. Thankfully, you can control when you sell the stock, which means you can control when you realize the taxable income from the gain.

When you own a mutual fund, you own a slice of a larger pool of investments such as stocks, bonds, etc. The fund manager of that pool of investments decides what securities to sell, and when. As securities are sold for a gain, mutual fund regulations are such that all gains need to be passed on to the fund holders in the year of the sale. Those gains are ”capital gain distributions.”

As mentioned above, you control when you realize taxable capital gains of individual shares of stock because you control when you sell the shares. But with a mutual fund, you don’t control when the fund’s stocks and bonds are sold; the fund manger does. As such, even if you don’t sell any of your shares of the mutual fund throughout the year, you may still get taxable capital gains passed on or “distributed” to you as a result of sale activity within the fund.

There is much more than this to capital gain distributions, and the rules can get a bit tricky. Therefore, I laid things out in more detail in an episode of my podcast, Retirement Planning Education. Specifically, I discuss capital gain distributions in Episode 12 – What are mutual fund capital gain distributions.

Additionally, I also recently made a YouTube video, “What are mutual fund capital gain distributions?” to further elaborate on the topic.

Mutual fund capital gain distributions aren’t necessarily bad. As discussed in the podcast and video, they neither create nor destroy wealth. However, they do make things a bit more tricky and inefficient from a tax perspective, specifically when held in normal taxable brokerage accounts (but they are not an issue in qualified accounts like IRAs, Roth IRAs and Health Savings accounts because sale activity in such accounts does not have any present-year tax implications).

If you can control it, it would be best to not hold mutual funds in regular brokerage accounts. However, if regular brokerage accounts are all you have and you feel the strategy and diversification provided by mutual funds is best for you, then don’t let the tax tail wag the dog; dealing with capital gain distributions is less of a problem than not having investments that are properly allocated and diversified.