It’s that time of year when those of you holding mutual funds may see a capital gains distribution. If you’re new to investing, like me, you might be wondering what this distribution is, why you’re receiving it, and what the implications are.
Let’s start out with the most important thing: although it ostensibly looks like you’re receiving money, capital gains distributions generally aren’t good for shareholders. Let’s take a closer look at what’s really happening when you receive a capital gains distribution.
Capital gains come into play in two scenarios. The more familiar scenario is when you sell a stock or mutual fund. I hope nobody is too shocked that when you sell a stock or mutual fund for more than what you paid for it, you have to pay taxes on the gains. The less familiar scenario is when the manager of a mutual fund that you own shares of sells some of the stocks in the fund for a gain. That gain is passed on to the shareholders in the form of a capital gains distribution, and you have to pay taxes on it.
Ok, so you have to pay taxes on the capital gains. You might be asking, “so what? They’re giving me money, so it makes sense I’d have to pay taxes on it.” Sounds logical, except that when the fund makes the capital gains distribution, the share price drops by the same amount. Let’s say the share price of a mutual fund is $42, and they make a capital gains distribution of $2 per share. On the day they make the distribution, the share price will drop by $2. If you own 100 shares, your capital gains distribution would be $200. Your investment before the distribution was $4200, and once the share price drops, you will have $4000. If you reinvest the $200 capital gain, you will be right back where you started at $4200. So you’re paying taxes on $200 even though you yourself experienced no net gain.
Keep in mind though, that you reinvested those $200 at $40 per share, so even though you still have $4200, you now have 105 shares instead of 100. It’s the little silver lining.
When capital gains distributions are made, typically a portion of the distribution will be long term capital gains and a portion will be short term capital gains. This depends whether the fund held the stocks they sold for at least one year. Here are the tax rates for capital gains (assuming the rates increase as scheduled in 2013):
|Short Term Capital Gains Tax||Long Term Capital Gains Tax|
|≤15%||Ordinary Income Rate||0%||10%|
|>15%||Ordinary Income Rate||15%||20%|
So how can you avoid paying these taxes? There are two ways to get around these taxes. The first is to hold mutual funds that distribute capital gains in a tax advantaged account, such as a Roth IRA. The other way is to avoid investing in funds that distribute capital gains. You can tell if a fund distributes capital gains by looking at their distribution history, but you can also get a pretty good sense by looking at the fund’s turnover rate. The turnover rate is the percentage of holdings within the fund that change each year. The higher the turnover rate, the more likely it is that the fund will distribute capital gains. Additionally, a very high turnover rate will result in more short term capital gains, which will increase your tax bill further. Index funds typically have much lower turnover rates than actively managed funds.
Finally, if you want to invest in a fund that distributes capital gains in a taxable account, but wish to minimize your tax burden, wait until after the distribution to invest. If you invest soon before the distribution is made, you’ll wind up paying taxes on gains that you weren’t even around to benefit from.
Ultimately this is a personal decision. There are plenty of great funds with a long history of solid performance that distribute capital gains. But it’s something that quite a lot of people (myself included) did not consider when evaluating mutual funds, so I urge you to do your research. Know if there’s a good chance the fund your investing in will distribute capital gains and know if that distribution is likely to be a significant one that could result in a large tax bill.