Mutual and exchange-traded funds (ETFs) make capital gains distributions when they pay out some of the money they've made from selling stocks and other assets. It represents the proportion of the fund's earnings that the investor is entitled to receive.

However, it does not mean a stake in the fund's profits. Your account value will fluctuate throughout the year based on the fund's performance, which could be an increase or a decrease. However, capital gains distributions will be made to shareholders if the fund realizes a profit from selling any of its stocks during the year.

Distributions of capital gains to shareholders of mutual funds are mandated by law and should be made regularly. Mutual fund shareholders can choose between cashing out their capital gains distributions or reinvesting them in more fund shares.

Distributions of Capital Gains: An Overview

A mutual fund or ETF pays out a capital gains distribution once a year, typically at year's end. The distribution is the net gain from the fund's managers' sale of shares or other assets during the taxable year. The distribution amount will be subtracted from your total invested capital in the fund.

Distributions of Capital Gains and Their Tax Implications

Investors who receive capital gains distributions from mutual funds with an ownership stake must report and pay taxes on that income. However, municipal bond funds are exempt from federal and typically state income taxes.

If the investor has the fund as part of a tax-deferred retirement plan, such as an individual retirement account (IRA), 401(k), or 403(b), then no tax is due for that tax year. When the money is withdrawn in retirement, taxes must be paid. With a qualified retirement plan, you can pay taxes on the funds for the current year.

The Present IRS Rules

Distributions of capital gains from holdings in a mutual fund or exchange-traded fund are treated as long-term capital gains under current IRS regulations. Therefore, the tax rate could be zero, fifteen, or twenty percent, depending on the person's standard income tax bracket.

If you despise paying taxes as much as I do, you should investigate tax-efficient investments, such as tax-efficient funds. Funds that minimize taxes label themselves as such. They may hold some municipal bond funds for tax-free income and trade stocks less frequently than aggressive growth funds.

Capital gains may be distributed even if the fund's value as a whole has decreased throughout the year. In other words, losses from other investments could nullify a fund's profits from the sale of appreciated stocks.

The Net Asset Value and Distributions of Capital Gains

Distributions of capital gains and dividends have the same effect on a mutual fund's NAV as on a stock portfolio. For instance, if a fund's NAV per share is $20, the manager could distribute $5 to investors. If this happened, the fund's NAV would drop by $5 to $15. Mutual fund price charts will show a drop on the ex-dividend day, but the fund's overall return will not be affected. The mutual fund's net asset value is based on its unrealized gains until securities are sold.

How Do You Pay Taxes on a Distribution of Capital Gains?

When a mutual fund distributes capital gains to its shareholders, they pay taxes on such profits. Distributions of capital gains from holdings in a mutual fund or exchange-traded fund are taxed as long-term capital gain regardless of how long the investor has held the fund's shares, at a rate of either zero, fifteen, or twenty percent, depending on the investor's marginal tax rate.2

Expenses vs. Capital Gains

Long-term capital gains are taxed lower than short-term capital gains, and vice versa. The capital gains treatment for buying and selling shares of an ETF or mutual fund is standardized for both the long and short term. Gains distributed from exchange-traded and mutual funds are taxed at the long-term capital gains rate regardless of whether the fund was held for over a year.

Mutual and exchange-traded funds (ETFs) can also generate income through dividends. Qualified and non-qualified dividends are often reported separately and subject to differing tax rates. Generally, a taxpayer's yearly tax report from an ETF or mutual fund will detail the investor's revenue in fine detail for use in the taxpayer's tax filing.