When an investor sells a stock for more than the purchase price, the investor experiences a capital gain (I like to call it a profit, but let’s stick to some technical terms for a minute). For example, if you bought Amazon at $820 back in January of 2017 and sold it for $1,020 in July 2017, the capital gain would be $200.
Mutual funds operate in much the same way, although it gets a little more complicated. When a mutual fund sells a stock for a profit, it too receives a capital gain and is required by law to pay most of the gain to its shareholders in the form of distributions – after deducting the fund’s operating expenses.
There are two types of mutual fund capital gains – long-term and short-term.
If the mutual fund – not the mutual fund investor, the mutual fund itself – has held the stock for more than one year, then the profit from the sale is treated as long-term capital gain, which is subject to a more favorable tax rate. On the other hand, if the mutual fund has held the stock for less than one year, then the profit from the sale is treated as short-term capital gain, and is taxed at the fund investor’s ordinary income tax rate.
Mutual fund firms usually begin estimating and publishing their capital gain distributions in the fall and then make final distributions before the end of the year. CapGainsValet is a good resource to use when projecting capital gains distributions for your specific mutual funds holdings. You should know that mutual funds don’t all make distributions on the same day – they just need to do so before December 31st. And to help you keep track of the distributions and whether they are short- or long-term, mutual funds report this information to shareholders on IRS Form 1099-Div after the end of every year.
Given all this, investors should be aware of purchasing mutual fund shares right before the mutual fund makes a distribution – a term called “buying the dividend.” Generally speaking, investors planning a large lump-sum investment in a mutual fund though a taxable account(s) should avoid buying-the-dividend.
Finally, it is also important to note that there are four types of mutual fund distributions that have tax implications for investors – capital gains, ordinary income (ordinary dividends), qualified dividends, and non-dividend distributions (often called return of capital). This time of year is also an excellent time to review your portfolio holdings to confirm you are invested in a tax-efficient way. It’s also important to discuss the implications of mutual fund investing and taxes with your financial advisor.