Ah, the season of holiday cheer, New Year's wishes, and � capital gains? Yes, 'tis the season of tax confusion, too, especially if you own shares in mutual funds.
On the surface, capital gains distributions are a good thing, in that a fund can't make them unless some of the securities it owns have appreciated in price and the manager has sold the shares at a profit. That's called a realized capital gain. Funds can also have unrealized capital gains on their books, meaning that they're holding securities that have gone up but they haven't sold them yet. (Unrealized gains are a nonevent from the standpoint of current taxes; no one has gotten paid anything yet, so the Internal Revenue Service can't yet demand a cut.)
But if a fund has a realized gain, it must distribute those winnings, along with any investment income (dividends and interest, minus expenses), to shareholders before year-end. And when it does, shareholders will receive the capital gains distribution. You can either pocket that money or reinvest it in the fund. If you reinvest your capital gain, the dollar value of your holdings won't be affected by the distribution.
Here's the rub, however. No matter what you choose to do with your distribution, whether you spend it or reinvest to buy more shares of the fund, you'll owe taxes on that amount, provided you own the fund in a taxable account and you can't offset your gain by selling losing positions elsewhere in your portfolio. If the manager held the security for more than a year, it's considered a long-term capital gain and that distribution is currently taxed at a relatively low rate of 0%-15%. But if the manager sold a security after holding it for less than a year, it's considered a short-term gain and taxed as ordinary income. (Many funds distribute a combination of short- and long-term capital gains.)A Simple Illustration
Here's a simplified example of how a capital gains distribution works. Say you invested $10,000 in a fund just as the market was taking off in March 2009; your investment purchased 1,000 shares of a fund whose net asset value was $10. During the past couple of years you've seen some pretty good appreciation, so the fund's NAV is now around $15 and the total dollar value of your portfolio is now $15,000. Some of that appreciation in NAV ($2 worth) is because of appreciation in holdings that are still in the portfolio, while another $3 worth of capital gains owes to appreciation in holdings that management has since unloaded. (Let's assume, for the purpose of this illustration, that all of the realized gains were long-term capital gains--that is, the manager had held the position for a year or more before selling.)
Nobody has gotten paid any cash for the $2 worth of unrealized appreciation (the holdings still remain in the portfolio), so the IRS isn't concerned about it. In the case of the $3 in realized appreciation, however, the fund has gotten paid and the IRS wants its cut. Thus, the fund must send that $3 per share to shareholders, who in turn will owe taxes on it. On the day the fund makes its distribution, the fund's net asset value drops from $15 to $12.
If you're not reinvesting capital gains, you'd get a check for $3,000 ($3 multiplied by your 1,000 shares) and the value of your portfolio would drop to $12,000 ($15,000 starting value minus $3,000 in capital gains) on the distribution date. You've pocketed some money, so it's only natural that the IRS would want a piece. You'd owe capital gains taxes on the distribution.
If you were reinvesting your capital gains, that $3-per-share ($3,000) payout would go right back into the fund, so the total value of your holdings would stay the same, at $15,000. From that standpoint of your investment holdings, the distribution is a nonevent, even though your NAV went down. Unfortunately, it's not something the IRS ignores. You'll owe taxes on that money even if you haven't pocketed a profit yourself.
That's one reason that Morningstar has been a vocal proponent of reforming mutual fund tax treatment
--we think shareholders should owe money only when they sell, just like stock investors. With budgetary concerns roiling Washington, I'm not hopeful that Congress will undo a provision that lets investors put off paying taxes. But that would be the fair thing to do.
At the same time, that's not to suggest you have to take unwanted capital gains distributions lying down. When shopping for your taxable account, you could focus on funds that are either explicitly managed to limit capital gains distributions or are naturally tax-efficient, such as many broad stock market index funds and exchange-traded funds. You could also get cute and try to unload the fund before it makes a distribution, but if it's a fund you really like, such a maneuver could amount to cutting off your nose to spite your face. Finally, you could sift through your portfolio before year-end to identify holdings that have lost value since you purchased them. If you sell your losers and realize a capital loss, you can use that money to offset any fund-related taxable capital gains that you might owe.See More Articles by Christine Benz
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