Grasping Mutual Fund and ETF Capital Gains Distributions

Alina Myakota |

Capital gains distributions are an integral part of investing in mutual funds and ETFs. Let’s delve into the essence of these distributions and what they mean for investors.

What is a Capital Gains Distribution?

When a mutual fund or ETF sells stocks or other assets from its portfolio, it distributes the proceeds to its shareholders. Shareholders can choose to receive these distributions in immediate payments or reinvest them in the fund to buy additional shares. 

Holders of mutual fund shares are liable to pay taxes on capital gains distributions, even if the money is reinvested. An exception exists for tax-exempt funds like municipal bond funds at the federal and often state levels. Taxes are deferred if the funds are held within an IRA or another tax-deferred retirement plan. However, upon withdrawal, taxes will become due. If the fund is not within a retirement plan, taxes must be settled for the current tax reporting period.

Under existing IRS regulations, capital gains distributions are taxed as long-term capital gains. This can incur a 0%, 15%, or 20% tax rate, dependent on the individual's ordinary income tax rate. Tax-efficient investments might be explored to mitigate taxes, especially funds that limit the frequent buying and selling of stocks.

Capital Gain vs. Capital Gain Distribution

Capital gains are any increase in a capital asset's value. Capital gains distributions are payments a mutual fund or an exchange-traded fund makes to its holders that are a portion of proceeds from the fund's sales of stocks or other portfolio assets. Capital gain distributions are typically paid out once a year, in December. 

Investing in mutual or exchange-traded funds means you might receive a capital gains distribution, regardless of whether you sold any shares. Understanding these distributions and their implications is crucial. Consider exploring tax-efficient investments and report the distributions appropriately to ensure compliance with tax regulations.