Each November the majority of mutual fund companies announce and distribute capital gains to each of their shareholders. Capital gains are realized anytime you sell an investment and make a profit.
And, yes this applies to all mutual fund shareholders even if you didn’t sell your shares during the year. I admit it can be confusing, but it all has to do with how mutual funds are structured.
How does it work?
Let’s forget we are talking about mutual funds for a minute and picture your favorite restaurant. The chef creates the menu and selects the ingredients for each of the dishes. As a patron of the restaurant, you are paying for their expertise and ability to create the perfect dish. The chef makes the decisions, puts it all together, and serves their masterpiece. Voilà!
Mutual funds work in a very similar way. They are created by pooling together dollars from investors. These dollars are then used to buy a collection of ingredients like stocks, bonds, and other investments. The person who makes the decisions on what to buy or sell is the fund manager or “chef”. This pool of investments is then divided into shares or portions and “served” to the shareholders. At the mutual fund restaurant, there are no special requests and no ingredients can be eliminated. Everyone gets the same dish.
How can you manage your capital gains?
As a mutual fund shareholder, you are entitled to profits the fund makes. Capital gains are generated when the manager sells a position for a profit. These gains are then passed on to you. In other words, it’s all based on what decisions the manager or “chef” makes. In fact, funds generating a profit are required to distribute them at least annually to avoid paying taxes themselves.
Do your research- avoid managers that buy and sell incessantly
It’s possible to select funds with low turnover. This means the manager does not buy and sell often within the fund. This information is provided by the fund and stated as the turnover ratio. For example, a turnover ratio of 50% means half of the investments in the fund have been replaced during the year. Make sure to look at the fund’s website for this information.
Sell your fund before the capital gains distribution takes place
This is definitely an option but remember, you will want to evaluate whether or not you’ve made a profit on your shares. If you’ve made a profit you will have a capital gain that may be subject to taxes. Also, it helps to evaluate from a bigger picture perspective. Are you selling just to avoid taxes or does the sale make sense in the context of your investments and financial plan?
Hold mutual funds in a retirement account instead of in an individual account
Remember, if you hold a mutual fund in a retirement account like a 401(k) or IRA you don’t have to worry about capital gains distributions. These accounts are taxed at ordinary income (not capital gains) rates only when you make withdrawals.
Select different types of investments
Individual stocks, bonds, and some ETFs do not pass through capital gains. When selling these investments the capital gains are based solely on when you sell.
So yes, it’s possible to have capital gains without selling anything thanks to the “chef”. Normally, capital gains distributions are close to year-end, but the frequency can vary from fund to fund. Check with your fund company for more details.
Interested in learning more? Read more about my firm, and check out my service options.
Disclaimer
The information on this site is provided “AS IS” and without warranties of any kind either express or implied. To the fullest extent permissible pursuant to applicable laws, Simplicity Wealth Management LLC (referred to as “SWM”) disclaims all warranties, express or implied, including, but not limited to, implied warranties of merchantability, non-infringement, and suitability for a particular purpose. SWM does not warrant that the information will be free from error. None of the information provided on this website is intended as investment, tax, accounting or legal advice, as an offer or solicitation of an offer to buy or sell, or as an endorsem*nt of any company, security, fund, or other securities or non-securities offering. The information should not be relied upon for purposes of transacting securities or other investments. Your use of the information is at your sole risk. Under no circ*mstances shall SWM be liable for any direct, indirect, special or consequential damages that result from the use of, or the inability to use, the materials in this site, even if SWM or an SWM authorized representative has been advised of the possibility of such damages. In no event shall Simplicity Wealth Management have any liability to you for damages, losses, and causes of action for accessing this site. Information on this website should not be considered a solicitation to buy, an offer to sell, or a recommendation of any security in any jurisdiction where such offer, solicitation, or recommendation would be unlawful or unauthorized.
FAQs
As a mutual fund shareholder, you are entitled to profits the fund makes. Capital gains are generated when the manager sells a position for a profit. These gains are then passed on to you. In other words, it's all based on what decisions the manager or “chef” makes.
Do I pay capital gains on mutual funds if I don't sell? ›
At least once a year, funds must pass on any net gains they've realized. As a fund shareholder, you could be on the hook for taxes on gains even if you haven't sold any of your shares.
Why does my mutual fund have capital gains? ›
One of the ways the fund makes money for you is to sell these assets at a gain. If the mutual fund held the capital asset for more than one year, the nature of the income from a sale of the capital asset is capital gain, and the mutual fund passes it on to you as a capital gain distribution.
Do you pay taxes on investments if you don't sell? ›
Some taxes are due only when you sell investments at a profit, while other taxes are due when your investments pay you a distribution. One of the benefits of retirement and college accounts—like IRAs and 529 accounts — is that the tax treatment of the money you earn is a little different.
How to avoid mutual fund capital gains distributions? ›
The best way to avoid the capital gains distributions associated with mutual funds is to invest in exchange-traded-funds (ETFs) instead. ETFs are structured in a way that allows for more efficient tax management.
Why do I have capital gains if I didn't sell? ›
That's because mutual funds must distribute any dividends and net realized capital gains earned on their holdings over the prior 12 months. For investors with taxable accounts, these distributions are taxable income, even if the money is reinvested in additional fund shares and they have not sold any shares.
Are capital gains taxed if not sold? ›
A tax on capital gains only happens when an asset is sold or "realized." Investors can also have unrealized and realized losses. An unrealized loss is a decrease in the value of an asset or investment you own but haven't yet sold—a potential loss that exists on paper.
Do you have to pay capital gains after age 70? ›
Whether you're 65 or 95, seniors must pay capital gains tax where it's due. This can be on the sale of real estate or other investments that have increased in value over their original purchase price, which is known as the “tax basis.”
How much capital gains are tax free? ›
For the 2024 tax year, individual filers won't pay any capital gains tax if their total taxable income is $47,025 or less. The rate jumps to 15 percent on capital gains, if their income is $47,026 to $518,900. Above that income level the rate climbs to 20 percent.
How to offset capital gains tax? ›
Utilize tax-loss harvesting
This strategy involves selling underperforming investments and booking a loss. You can use these capital losses to offset taxable investment gains and up to $3,000 each year of ordinary income.
Hold Funds in a Retirement Account
This means you can sell shares of your mutual fund or collect a capital gains distribution without paying the relevant taxes so long as you keep the money in that retirement account. You will ultimately owe any related taxes once you withdraw the money, of course.
Where do I report capital gains on mutual funds? ›
In case of short-term capital gains, you need to report it in Schedule CG of the ITR form. Whereas in case of long-term capital gains exceeding Rs. 1 lakh, you need to report it in Schedule 112A. When specifying the type of capital assets sold by you, choose equity shares or bonds and debentures accordingly.
Can you switch mutual funds without capital gains? ›
Investors can switch mutual funds without selling their shares and paying capital gains taxes, which allows them to change their investment approach. A switch fund investment organisation takes money from several investors and buys equities, bonds, and short-term debt.
Do you pay capital gains if you don't make a profit? ›
The tax doesn't apply to unsold investments or unrealized capital gains. Stock shares will not incur taxes until they are sold, no matter how long the shares are held or how much they increase in value. Most taxpayers pay a higher rate on their income than on any long-term capital gains they may have realized.
Do you have to report capital gains if you don't withdraw? ›
Yes, taxes are paid on when you sell the securities at a gain, regardless of whether you withdraw it or not. However, if those gains were made in tax advantaged accounts like IRA or 401(k), you may not have to pay taxes on those gains.
Are capital gains taxed if they are reinvested? ›
A capital gains distribution is the investor's share of the proceeds of a fund's sale of stocks and other assets. The investor must pay capital gains taxes on distributions, whether they are taken as cash or reinvested in the fund.
Do you pay capital gains twice on mutual funds? ›
Mutual funds are not taxed twice. However, some investors may mistakenly pay taxes twice on some distributions. For example, if a mutual fund reinvests dividends into the fund, an investor still needs to pay taxes on those dividends.
