By Theresa Fry, Senior Vice President and Manager, IRA’s and Retirement Planning
If you own mutual funds in your taxable investment account, you may have been surprised to find capital gains reported even though you did not buy or sell any shares. Mutual Funds must distribute dividends and any realized capital gains earned in the prior 12 months. They are considered taxable unless you hold the shares in a tax-deferred account such as an IRA or 401(k) plan. These distributions are typically paid at the end of the year to shareholders of equity mutual funds.
When a fund pays distributions to shareholders, they can be long-term capital gains, short-term capital gains or dividends. The long-term or short-term nature of the distribution is based on how long the fund held the investment, not how long you, the investor, held shares of the mutual fund.
Long-term capital gains and qualified dividends are subject to tax rates of 0%, 15%, or 20% depending on your income, and high-income earners ($200,000 for individuals, $250,000 for married taxpayers filing jointly) must add on the 3.8% net investment income tax to that rate. Short-term capital gains, which are considered ordinary dividends, and other ordinary dividends are subject to income tax rates. Net capital losses are not distributed to shareholders. The fund carries the losses over to be used to offset future capital gains of the fund.
When capital gain distributions are paid, the net asset value of the mutual fund drops by the amount of the distribution. The value of your holdings does not change whether you reinvest or not, even though you have taxes that may have to be paid.
Consider this example: You own 1,000 shares of ABC mutual fund at $10 a share for a value of $10,000. After the fund manager sells portfolio holdings a 10% capital gain is distributed resulting in each shareholder receiving $1 per share. Because the net asset value drops to $9 per share after the fund distributes the capital gain, reinvesting results in 1,111.111 shares at $9 a share. If you don’t reinvest, you hold 1,000 shares at $9 per share and $1,000 cash. Either way, you still have $10,000 and either way, you have a $1,000 gain to report.
Mutual fund capital gain distributions are reported to you and the IRS on Form 1099-DIV. Short-term capital gains are distributed as ordinary dividends (Box 1a). Distributions of net investment income are included as ordinary or qualified dividends (Box 1a or 1b). Long-term capital gain distributions are included in total capital gain distributions (Box 2a).
Capital gain distributions are an inevitable part of mutual fund investing. If you are concerned about tax exposure due to mutual fund capital gain distributions, tax efficient mutual funds may help. They try to limit capital gains by keeping the portfolio’s turnover rate low or by harvesting losses to offset portfolio gains. In addition, by investing in a tax-deferred retirement account, you won’t owe taxes on any capital gain distributions or dividends when paid by the mutual fund. Instead, you will pay income tax on any distributions you take from the retirement account, which is typically during your retirement years.
While taxes play an important role in making investment decisions, your goals and objectives should take priority. Contact a financial advisor today if you would like to review your investments or discuss a more tax efficient approach to investing.
Benjamin F. Edwards does not provide legal or tax advice, therefore it is also important to consult with your legal and tax professionals for additional guidance tailored to your specific situation.