Understanding mutual fund capital gain distributions
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 brokerage account’s consolidated 1099, even though you most likely didn’t actually sell any of the fund AND didn’t get any cash distributed out to you. This is likely due to capital gain distributions.
When you own shares of a stock, for example, in a normal brokerage account, you have to pay tax on any realized gains you have on that stock. 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 on its sale.
When you own a mutual fund, you own a slice of an entity that owns 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, within the pool. As securities are sold for a gain within the pool, mutual fund tax regulations are such that all of those gains need to be passed on to the underlying fund holders in the year of the sale. Those are capital gain distributions.
Here are the key things to know about capital gain distributions:
Active vs passive mutual funds
Capital gain distributions are rather common in actively managed mutual funds. They are minimal, if any, in passive/index mutual funds, such as funds that seek to replicate the S&P 500.
This is a function of active funds typically having more “turnover” in their holdings, as the fund manager trades in and out of positions as they feel appropriate for the fund, or as the fund’s stated investment mandate requires.
With an index fund, the fund’s positions are what they are, and often don’t change much. So there is less sale activity, and therefore less gains to be passed on to fundholders. The fund is simply invested such that its holdings mimic the constituents of the index the fund is trying to replicate. Generally speaking, the fund would only trade out of positions if that underlying company is removed from the index.
Short-term vs long-term distributions
If you hold an investment for 12 months or less before you sell it at a gain, that will be treated as a “short-term” gain, and will taxed at your ordinary income tax rates.
Conversely, if you hold an investment for more than 12 months before you sell it at a gain, that will be treated as a “long-term” capital gain, and federally taxed at lower rates than the rates that apply to ordinary income (but it likely will still be taxed as ordinary income at the state level, if you live in a state with income tax, as most states don’t have preferential tax treatment for long-term capital gains).
The same short-term vs long-term treatment applies to mutual funds when they sell one of their holdings. And that short-term vs long-term treatment is passed through to you, the fundholder, when the fund distributes that gain.
With that said, the reporting of these two types of passed through gain distributions will show up differently on your 1099-DIV tax report from your custodian.
Any short-term gains the fund realized during the year will be reported as ordinary dividends on your 1099-DIV; specifically they’re included in box 1a of 1099-DIV. Because short-term gains are treated as ordinary income, they’re simply lumped in with ordinary dividends on your tax reporting, because ordinary dividends receive the same tax treatment. So there isn’t really any reason to need to distinguish between short-term gains and ordinary dividends.
Any long-term capital gains the fund realized during the year will be reported as capital gain distributions on your 1099-DIV; specifically in box 2a. This amount will be taxed to you as long-term capital gains, at the reduced tax rates mentioned before.
You don’t need to hold the fund more than 12 months to receive the lower tax treatment on capital gain distributions
Capital gain distributions will always be federally taxable to you at the reduced long-term capital gains tax rates, even if you didn’t actually hold the fund more than 12 months.
Recall I said you need to hold an investment more than 12 months in order for any gain you realize on its sale to be taxed at the lower long-term capital gains tax rates. That still holds true if you were to sell out of some or all of your shares in the fund.
However, any capital gain distributions passed through to you as the fund holder will be taxable to you at the reduced long-term capital gains tax rates, even if you held the fund itself less than 12 months.
That’s because the underlying positions within the fund were held (by the fund) more than 12 months. Hence, gains on sales of those positions within the fund are deemed to be long-term, even if your holding of the fund has been less than 12 months.
Capital gain distributions are taxable even if you didn’t receive any cash from them
Many people who own mutual funds have them set up in their brokerage account such that any dividends or distributions paid by the fund are automatically reinvested into buying more shares of the fund. That’s generally the default treatment applied by the custodians. So, unless you consciously change your account’s preference to have mutual funds pay out dividends and distributions as cash, assume they will automatically get reinvested.
As such, if/when a mutual fund pays out a capital gain distribution, you may not actually see or receive any cash from it. For example, assume you own $1,000 worth of mutual fund ABCDX. And assume it pays out a $50 capital gain distribution in December. You won’t actually get that $50 of cash, as it will be pumped into buying more shares of ABCDX. However, you still have to pay tax that year on that $50. That’s because auto-reinvestment is functionally just you having made the choice to receive the cash and then immediately turn around and use it to buy more shares. So you did technically get the cash…but you chose to buy more shares of the fund with it.
Capital gain distributions neither create nor destroy wealth
Let’s go back to the example from above, where you have $1,000 of fund ABCDX and it pays $50 of capital gain distribution.
When the capital gain distribution of $50 is paid, the market value of the position immediately decreases by the amount of the distribution. So, in this example, your $1,000 position just decreased to $950. But you didn’t actually lose money. Either 1) the $50 distribution was automatically reinvested into buying more of the fund, bringing your total position value back to $1,000 (i.e. the original position which is now only worth $950, plus the $50 more you just bought into it) or 2) the distribution was paid out to you in cash, in which case you now have $950 worth of ABCDX plus $50 in cash, for a total of $1,000.
Capital gain distributions don’t create additional taxable income…at least not over the long-term
Up until now, you may feel like you’re getting skunked by getting taxable distributions forced upon you, specifically because you didn’t actually sell anything and you may not have even gotten any cash from it (because it was reinvested into more shares). However, you’re not necessarily worse off from a tax perspective. That’s because whatever taxable gains are getting passed through to you now from the distributions are reducing the amount of taxable gains you will otherwise have in the future.
Let’s again go back to the previous example; you own $1,000 of fund ABCDX. And let’s assume you originally paid $800 for it. As such, you have $200 of unrealized gain in that position.
After the $50 capital gain distribution, the $1,000 position value decreases to $950, like I mentioned above. So now your unrealized gain in the position is only $150, not $200. In other words, if you were to sell the position now, you’d have to pay tax on only $150 of gain; not the $200 you would have had before the capital gain distribution. That’s because you’re getting taxed on the $50 distribution, and that reduced the position’s market value (and remaining unrealized gain) by the same amount.
All that essentially happened was the fund pulled forward some of your unrealized gain from the future and forced you to realize it now. Hence, over the long-term, it’s not like you’re getting double-taxed or having to realize more gain than you otherwise would have. It’s just that the capital gain distribution is inconvenient from a tax planning perspective to have the timing of some of the gain realization be outside of your control.
Capital gain distribution amounts can fluctuate a lot year-to-year, and aren’t known until late in the year
If you have actively managed mutual funds in your brokerage account, the tax planning around capital gain distributions can be quite frustrating. That’s because the amount, if any, of capital gain distributions a fund might pay for the year won’t be known until late in the year.
Over the last handful of years, I’ve seen funds pay anywhere from zero to over 20% in capital gain distributions. While a distribution in the range of 20% is far from common, it’s not impossible. More practically, my experience is such that capital gain distributions are generally below 10%.
This means that if you own $10,000 of a fund and it pays a capital gain distribution of 5% for the year, you’ll have $500 of taxable income in that year from that distribution.
For those of you who like to do detailed income and tax projections early in the year, having large actively managed mutual fund positions in a normal taxable brokerage account will make your early-year planning and projections difficult. That’s because most fund managers don’t release estimates for the year’s distributions until October or so.
And, from one year to the next, the amount of capital gain distribution a fund pays can vary significantly. Which means you can’t simply assume a fund’s distribution for the current year will be the same as it was last year. However, in the absence of knowing the future, if you’re trying to do an income and tax projection for the year, you don’t really have any other way to ballpark a fund’s potential capital gain distribution besides looking at what it paid last year. Or maybe look at what it paid over the last few years and take the average of those amounts.
However, once the latter part of the year comes around and the fund manager releases its estimated distribution for the year, you can then revise and tighten up your projections. The preliminary distribution estimates made public in the Fall usually end up being pretty close to the actual final distributions for the year. And the final distributions typically aren’t paid until late-November or some point in December.
So, if you’re an eager beaver and are doing income tax projections early in the year, good for you! But seriously, there isn’t too much you can do to accurately project your funds’ potential capital gain distributions for that year. You have to make some kind of guess, and leave yourself plenty of buffer in your projections, so you can later refine things as necessary after the fund manager releases the estimated distribution amounts later in the year.
You don’t have to worry about this in qualified accounts
As referenced earlier, the tax hassles around capital gain distributions are only an issue when the fund paying the distributions is held in a normal nonqualified taxable brokerage account. That’s because you have to realize the tax implications of all taxable activities in that account in the year the activity occurs.
On the other hand, if the fund was held in a “qualified” account such as an IRA, Roth IRA or Health Savings Account, there are no current year tax implications to ANY dividends, interest, sales, capital gain distributions, etc. that happen within the account. It’s not that a mutual funds held in those accounts wouldn’t pay capital gain distributions. Instead, it’s simply a non-issue from a tax perspective when distributions happens inside a qualified account.
So, to the extent you want to own a mutual fund that is likely to pay capital gain distributions AND you can place that fund inside a qualified account, that would likely be more tax-efficient than owning the fund in a normal brokerage account.
Dealing with a fund owned in a normal brokerage account
If you already own such a fund in a normal brokerage account and want to try to get rid of it so as to not have to deal with the ongoing annual tax implications of its capital gain distributions, you unfortunately don’t have many options besides 1) selling it and realizing whatever gain (or loss) you might have on it, 2) donating it to charity and/or 3) gifting it to another person (which means you’d simply be transferring the ongoing tax implications to that person…)
For better or worse, if you own in a normal brokerage account a fund that pays capital gain distributions and you ideally want out of the position, the best solution (or least worst solution…) might unfortunately be to simply keep it and keep dealing with whatever capital gain distributions it throws off. This is likely to be the case if there is a lot of unrealized gain in the position (e.g. you bought it decades ago for $10,000 and now it’s worth $200,000), and selling it would mean a real chunky amount of taxable gain/income that year. That spiking of your income and resultant tax bite might be worse than just dealing with the smaller amounts of income and tax bites throughout the years from the annual capital gain distributions.
I hope you found this info helpful. Capital gain distributions aren’t the end of the world, but they’re definitely annoying, if nothing else. To the extent you can hold such funds in a qualified account instead of normal taxable brokerage account, that would be ideal. However, that may not always be feasible. In that case, being aware of how capital gain distributions work, how they’re taxed, and how to try to plan around them is the best you can do!