Year-End Financial To-Do: Prepare for Mutual Fund Distributions

By Ashlee Ogrzewalla, CFP®, Vice President and Manager of Financial Planning & Marketing

The distinctive nature of gains in 2023 has given rise to an exciting scenario where skilled portfolio managers have the potential to offset significant capital gains with realized losses throughout the year—a trend observed both internally and among the mutual fund managers Benjamin F. Edwards works with. 

 It’s worth noting that substantial capital gains from fixed-income strategies are unlikely this year, except in the high-yield sector. Similarly, large-cap growth strategies tend to experience higher distribution rates than other equity styles.

 When reviewing your year-end mutual fund account statement, you may notice that a fund distributed capital gains or dividends. The types of distributions can be confusing, so let’s delve into the differences. 

Types of Mutual Fund Distributions 

Securities held within mutual funds can generate capital gains and earn dividends throughout the year. Mutual funds are required to distribute any net capital gains and accrued income to their shareholders at least annually.

 These distributions can be reinvested back into the fund or paid out, but the choice does not affect the taxable status of the distribution. Distributions made by mutual funds held within tax-advantaged accounts, such as IRAs or 401(k)s, are not subject to taxation.

 There are four primary types of mutual fund distributions:

1. Capital Gains

These distributions result from the sale of securities within the fund throughout the year. The fund makes a distribution when there are more gains than losses, typically towards the end of the year. These distributions are categorized as either short-term or long-term gains. Short-term gains stem from securities held for less than one year, while long-term gains result from securities held for over one year. The tax rate for long-term capital gains varies from 0% to 20%, depending on the shareholder’s tax bracket. In contrast, short-term capital gains are taxed at the shareholder’s ordinary income tax rate.

2. Dividends

Dividends are cash distributions stemming from stock ownership. Dividends paid on securities held within the fund are typically accrued by the fund and distributed monthly or quarterly to shareholders. These ordinary dividends are taxable at the shareholder’s income tax rate. Some mutual funds make qualified distributions with a preferred tax rate of 15%.

3. Interest

Interest usually arises from fixed-income securities like bonds and certificates of deposit (CDs). Interest is accumulated and distributed like equity dividends and taxed at the shareholder’s ordinary income tax rate. From a mutual fund standpoint, ordinary dividends and interest are essentially treated the same.

4. Return of Capital

A return of capital distribution occurs when the fund returns a portion of the investor’s original investment. This return of capital is not a taxable event and is neither classified as a dividend nor capital gain distribution. Return of capital distributions are most common with real estate investment trusts (REITs) and master limited partnerships (MLPs). Tax considerations are crucial to any investment, and understanding why and how mutual funds make distributions can better prepare you. Employing savvy tax strategies, such as avoiding significant new investments into a mutual fund just before a capital gain distribution, can help you retain more of your money. Information is usually available on your financial statements or your institution’s website, showing if a fund you own has an unrealized gain or unrealized loss. If there’s an unrealized loss, you can visit the fund company’s website and find their expected capital gains for 2023. The easiest, most efficient way to manage the future tax impacts of mutual fund distributions is to consider holding them in a tax-deferred account, such as an IRA, instead of a taxable one. Your financial advisor can help pick which types of investments make sense to hold in which account type.   IMPORTANT DISCLOSURES: The information provided is based on internal and external sources that are considered reliable; however, the accuracy of this information is not guaranteed. This piece is intended to provide accurate information regarding the subject matter discussed. It is made available with the understanding that Benjamin F. Edwards is not engaged in rendering legal, accounting or tax preparation services. Specific questions on taxes or legal matters as they relate to your individual situation should be directed to your tax or legal professional.