What is a capital gains distribution?
A capital gains distribution is a cash payment that a mutual fund is required to send to shareholders, usually in November or December. The distribution is taxable, as it represents a share of the capital gains incurred by the mutual fund throughout the year.
There are two big reasons why these distributions occur. First, the mutual fund is constantly buying and selling stocks in an attempt to outperform the stock market average. Whenever a stock is sold at a gain, the mutual fund passes the gain – and the tax liability – proportionately to each shareholder.
Second, as investors withdraw their money from a mutual fund, the fund must sell stocks to generate cash for distributions. If the stocks are sold at a gain, the gain will be passed along to the remaining shareholders.
In this article, I will tell you the three things you need to know about capital gains distributions, followed by an example to illustrate the concept.
1. Capital gains distributions are not taxed in retirement accounts
Capital gains within tax-advantaged accounts (such as IRAs, Roth IRAs, 401(k)s, etc.) are not taxable. However, the mutual fund will still distribute the cash to your account, and it’s up to you to reinvest the cash or to set up an automatic reinvestment program.
2. Capital gains distributions reduce the value of the mutual fund
The distribution is not “free money”. Since the value of the mutual fund is equal to all assets inside the fund - stocks, bonds, cash, etc. – when the fund distributes some of its cash to shareholders, it now has less cash and thus a lower value.
In practice, most people utilize an automatic reinvestment program so their distribution will go right back to more shares of the mutual fund, leaving them with the same amount of money in your mutual fund, except for…
3. Capital gains distributions create tax drag
I’m sure you’ve seen videos of prototype cars in wind tunnels. The engineers go to great lengths to design a car with as little drag as possible; they know any unnecessary body part will catch the wind and make the car less efficient.
Short-term capital gains are taxed at ordinary income rates (the same as your income). Long-term capital gains are taxed at lower rates.
The same concept can be applied to your investments. A capital gain distribution is taxable, even if you are using an automatic reinvestment program. Paying this tax every year will reduce the after-tax return on your investment.
Example
“A $100,000 investment can create over $1,300 in taxes every single year.”
For this example, I chose the largest actively-managed mutual fund: AGTHX (if you work with an Edward Jones broker, you may be invested in this fund!)
American Funds (the manager) estimates that AGTHX shareholders will receive a distribution between 6.5% and 9.0% on December 19th of this year. Let’s be generous and assume it will be 6.5%.
If you have an investment of $100,000, you can expect a distribution of $6,500. Ignoring the change in the value of other assets in the fund, you would wake up on 12/19 with $6,500 in cash and $93,500 in AGTHX (remember, distributions reduce the value of your mutual fund).
The $6,500 must be reported as taxable income. Let’s be generous again and assume that the entire distribution will be taxed at the more favorable long-term capital gains rates. A modest Nebraska couple will be in the 15% federal tax bracket and 5.84% state tax bracket, meaning this distribution will create an additional tax of $1,354. Merry Christmas!
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What can I do about it?
First of all, let me state that nothing in this article should be taken as advice, and you should always seek help of a professional before making investment decisions.
It’s also important to never let the tax tail wag the investment dog. In other words, a hypothetical investment that earns 10% and creates taxes of 1% (9% net) is better than an investment that earns 7% with 0% tax, even if you must pay taxes on it.
With that said, there are a couple ways to mitigate or eliminate capital gains distributions.
1. Consider investments with fewer capital gains distributions
It sounds so obvious, right? There are thousands of mutual funds and ETFs available to invest in. Many funds utilize a passive strategy which limits the amount of capital gains incurred.
2. Place your high-distribution investments in a tax-advantaged account
As mentioned above, certain accounts are protected from capital gains. If you really like your high-distribution fund, consider holding it within one of these accounts.
About the Author
Joseph Fowler, CFP® is a financial planner and co-owner of 402 Financial in Lincoln, NE.
402 Financial provides financial planning and investment management services to people approaching or in retirement. Joe always acts as a fiduciary and never takes commissions on product sales.
Click this link to schedule a free consultation with Joe.
