Understanding Mutual Fund Capital Gains

Capital gains are a good thing. Unexpected tax bills are not. But the reality is that capital gains taxes are part of the normal (albeit unwelcome) 'price of admission' for investing. Specifically, it's the price of successful investing. Only those who successfully realize capital gains pay taxes on their success. In other words, it's a good problem to have.

How do capital gains work?

There are two kinds of capital gains with mutual fund investing. First, an investor incurs a capital gain from selling shares at a higher price than the price you paid for those shares. Second, capital gains also occur when  a mutual fund portfolio manager sells shares of a stock held in the portfolio at gain from the price he/she bought them (called realized capital gains). When the latter happens, the mutual fund must pay out those capital gains, at least once a year, in order to satisfy federal tax requirements. This payout is called a “distribution,” and it is paid to each shareholder on a pro-rata (equally portioned) basis.

Mutual fund capital gain “distributions” are broken down into two categories: long-term capital gains (LTCG) which occur when a stock is sold after being held in the portfolio for longer than one year; and short-term capital gains (STCG) which occur when a stock is sold after a holding period of one year or less. LTCGs are taxed at a rate of either 0%, 15% or 20%. STCGs are taxed as ordinary income, as are mutual fund distributions of dividends and interest, and this ordinary income tax rate is higher than an investor's long-term capital gains tax rate. Shareholders can choose to receive distributions in cash or reinvest them into their account. Even when distributions are reinvested, shareholders pay taxes on the amounts they receive (unless their assets are held in a tax-advantaged account, such as a traditional IRA or a Roth IRA).

Bond mutual funds also pay distributions. If an investor holds shares of a taxable fixed income mutual fund, then the interest earned from the bonds held inside the fund are generally paid out to shareholders, and these distributions are taxed as ordinary income. Occasionally a fixed income fund will also distribute a small LTCG or STCG.

Why do distributions cause fund prices to go down?

When a fund's realized gain outweighs losses, they accumulate inside the fund until distribution and contribute to the increase in the fund's share price — also known as the net asset value (NAV). When this gain is paid out in the form of a distribution, the fund's NAV decreases by the same amount of the distribution (ignoring any fluctuation in NAV attributable to market activity).

To explain this further, there are a few key terms to know.

• Record date: All shareholders of record at close of business on this day are eligible to receive the distribution.
• Ex-dividend date (ex-date): The date on which the per-share amount is deducted from the fund's NAV per share.
• Pay date: The date a fund pays the distribution to shareholders. This is also the reinvestment date for shareholders that choose to reinvest their distribution into the fund. The ex-date and the pay-date are both generally the business day after the record date.

For example, assume that today is the record date, and a fund has a NAV of $20. The fund then declares a distribution of $2 per share with an ex-date and pay date of tomorrow. Shareholders who own the fund today will be entitled to receive the distribution, but anyone buying on, or after, the ex-date will not.

Additionally, suppose you held 1,500 shares of the mutual fund on the record date with a market value of $30,000 (1,500 x $20 per share). You would receive $3,000 ($2 per share x 1,500 shares) in distributions on the pay date. Your 1,500 shares would now be worth $27,000 (1,500 x $18 per share). If you reinvested your distribution, your $3,000 would purchase an additional 166.667 ($3,000/$18 per share) shares on the pay date. Your new share balance would be 1,666.667 (1,500 shares + 166.667 shares), still with a market value of $30,000. The shareholder purchasing shares of the fund on the ex-date will buy shares at $18 (again, ignoring fluctuations in NAV due to market activity).

When capital gains or income distributions are reinvested into a mutual fund shareholder's account, the payout increases the cost basis on that account. This is because the distribution is part of the shareholder's tax information for the year it is paid.

Why do capital gains occur even when markets are down?

Capital gains are not tied to current market or fund-level performance, they are determined by the sale of securities within a fund. Even when markets are down, the sale of a security can still generate a gain, for example if the gain had appreciated over many years.

How do mutual fund distributions differ from other types of investments?

All mutual funds, including index funds, are required to pay out any realized gains to shareholders on a pro-rata basis at least once a year. Typically, actively managed equity mutual funds do so annually in the form of short-term and long-term capital gains. The total capital gain payout will vary from year to year, and there may be years when a mutual fund does not pay out any distribution. Index funds typically pay dividends quarterly (which are taxable as ordinary income).

Investors who buy individual stocks pay the capital gains taxes the year(s) they sell shares. If the stock is a dividend payer, then the investor will generally receive those dividends in cash on a quarterly, biannual, or annual basis and pay income tax on the total amount received each year.

Paying taxes is part of any successful investing process, and mutual funds have the added benefit of providing shareholders with a diversified portfolio managed by an investment professional.