What You Need to Know About Capital Gains Distributions
If you own mutual funds in a taxable account, you may find yourself with a tax bill despite not having sold a single share.
Question: Do I have to pay taxes on mutual fund capital gains, even if I don't sell any shares of the funds?
Answer: Unfortunately, sometimes the answer is yes. If you own mutual funds in a taxable account, you may find yourself with a tax bill for mutual fund capital gains and income distributions. And you may have to pay taxes on these gains even if you didn't sell a single share, and even if you reinvested the income or capital gain right back into the fund and never received a check.
When you sell a security for a higher price than you bought it for, you "realize" the gain. The amount in excess of your original purchase price is your profit, and you’ll have to pay taxes on it. How long you’ve owned the security for often influences the tax rate you will pay. For instance, if you sell a security that you’ve owned for less than one year, it is taxed at your ordinary income tax rate.
If you sell a security you’ve held for more than one year, it is generally considered a long-term gain and is taxed at a favorable tax rate of 15%. Taxpayers earning below $80,000 pay 0% on long terms capital gains, and households earning above $496,600 ($414,450 for single filers) pay 20%. Qualified dividend income is also eligible for favorable tax treatment. (See this explainer by the IRS for more.)
If you sell a security for less than you paid for it, that is called a capital loss. You can use up to $3,000 in capital losses to offset capital gains, or ordinary income. Unused tax losses (above the $3,000 yearly limit) can be carried forward for use in future tax years.
When a mutual fund sells securities that have appreciated in value and the fund doesn't have any offsetting capital losses, it must distribute those gains, as well as on any dividends or income payouts, to shareholders. Shareholders, in turn, are required to pay taxes on the gains (assuming they don't have any offsetting capital losses in their own portfolios). Capital gains distributions are usually paid out once per year, typically in December. You can find information about estimated fund distributions, including the total amount, percentage of NAV (if provided), and scheduled payout date on the fund company's website usually starting in November and December.
Morningstar's potential capital gains exposure data point, which is available on our fund quote pages under the Price tab, can also give you an idea of how much of a fund's assets consist of appreciation (capital gains) that could eventually be distributed if the securities were sold.
- source: Morningstar
One important caveat: A high PCGE score means the fund's portfolio contains a lot of securities that have increased in value, but it doesn't necessarily mean that a big distribution is imminent. A fund whose strategy involves actively buying and selling stocks opportunistically will have a higher turnover ratio than a fund that passively tracks a market-cap-weighted benchmark. A high PCGE score combined with a high turnover ratio is a better indicator of possible future capital gain distributions. (You can find a fund's reported turnover data point on the Portfolio tab of its Morningstar.com quote page.)
- source: Morningstar
Mutual fund NAVs, or net asset values, can be affected by these distributions. A fund's NAV is calculated by taking the value of its assets (such as stocks, bonds, and cash), subtracting its liabilities (such as expenses), and dividing by the total number of shares outstanding. Capital gains and income distributions reduce a fund's NAV by the amount of the distribution per share, but they don't have a direct impact on the same fund's total return, which is calculated by looking at the beginning and ending values of an investment, taking these distributions into account.
If you're holding mutual funds in a taxable account, there are a few things you can do to reduce the tax impact of capital gains distributions. First, you can scout around for offsetting losses in your portfolio: Examine your portfolio for securities where your cost basis is above the security's current price.
If you wanted to sell the securities anyway, or can easily swap into a similar investment after booking a loss, you can use the capital loss to offset the gain. Beware the wash-sale rule when employing the latter tactic, though. The IRS tries to prevent people from selling a security to use the tax-loss benefit and then rebuying it or a "substantially identical" security within 30 days of the sale. If the security is similar enough, it can be considered a wash-sale and will disqualify you from claiming the tax loss.
In most cases, selling a fund pre-emptively just to avoid the distribution doesn't make sense. However, if you're shopping for a mutual fund for a taxable account late in the year, you may want to time your purchase after this payout has occurred to avoid paying taxes on the distribution.
Ultimately, an investor's best weapon against unwanted taxable income or capital gains distributions is to pay attention to which assets you hold in tax-deferred accounts (such as 401(k)s and IRAs) versus taxable accounts (such as brokerage accounts). Certain types of investments tend to be less tax-efficient because they are more likely to pay out taxable income or gains than others. These include high-turnover actively managed funds, some types of bond funds including high-yield corporate-bond funds, and REIT funds. Such holdings are a better fit inside of a tax-advantaged account such as a 401(k), IRA, HSA, 529, and the like. By contrast, municipal-bond funds as well as many index funds and ETFs can be good choices for taxable accounts.