Here’s what you should know about how mutual fund short-term capital gains are distributed.
What Are Mutual Fund Capital Gains Distributions?
Mutual fund shareholders face the prospect of receiving capital gains distributions from their mutual funds each year. They’re the result of the mutual fund selling securities within the fund. A mutual fund might start out the year holding a stock like General Electric then, during the year, the fund manager may decide to sell those shares at a capital gain. They must pass those gains onto the shareholders when they do so. This is most often done in lump sums at the end of the year. All the gains from all the sales throughout the year are distributed among shareholders in one payment.
Long-Term vs. Short-Term Capital Gains Distributions
Any gains as a result of that sale are considered “short-term capital gains” when a mutual fund sells shares it has owned for one year or less. They’ll be distributed to shareholders as short-term capital gains. These are taxed at the same rate as ordinary income. But what if a mutual fund sells shares that it’s owned for more than 12 months? In that case, any gains as a result of the sale are classified as “long-term capital gains.” They’ll be distributed as long-term capital gains and subject to long-term capital gains taxes. These are more favorable than ordinary income tax rates. Shareholders may face both long-term and short-term capital gains distributions. This is a result of owning shares in a particular mutual fund. It doesn’t matter how long the fund has been held. The applicable time frame is based on the mutual fund’s holding period for the securities within the mutual fund. It’s not about how long the mutual fund’s shareholder has held the mutual fund itself.
Short-Term Capital Gains Distributions
The difference between short-term capital gains and short-term capital gains distributions can be confusing. Let’s say you own a mutual fund for a few months, then sell it for a gain. You’ve incurred a short-term capital gain in this case. What if the fund was held in a taxable account? The net result is a short-term gain if you don’t have enough losses to offset this gain. You’ll have to pay ordinary income tax rates on the amount of money you made as a result of the sale. You gained from buying and selling shares in the mutual fund in this scenario. You can use any short-term gains you might realize against other capital losses to reduce your tax liability. But this isn’t quite the case when it comes to short-term capital gains distributions from a mutual fund. You must instead report them on your tax return as ordinary income if you own a mutual fund that subjects you to short-term capital gains distributions. Unlike short-term capital gains, capital losses don’t offset short-term capital gains distributions and reduce your tax liability.
The Bottom Line
This situation might quickly become a problem to the extent that you’d planned to reduce your tax bill by using tax loss harvesting strategies or investing in tax-efficient funds. You might be unpleasantly surprised at tax time when you owe more in taxes than you had planned if you or your financial advisor believe that short-term capital gains distributions are just like short-term capital gains. The Balance does not provide tax or investment advice or financial services. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.
