When Mutual Funds Distribute Capital Gains

by Craig Moser on November 3, 2017

What happens when mutual funds distribute capital gains?  Selling at a profit generates short-term and long-term gains.  Distributing short-term capital gains as income dividends makes them subject to ordinary income taxes.

Stocks and/or bonds pooled into one investment that usually centers on a common theme make up mutual funds.  A fund realizes a capital gain every time it sells an investment for more than its purchase price.  A fund may also have a capital loss when it sells an investment for less than it paid for it.  At the end of the year, funds could have two types of capital gain distributions: Short-term and long-term gains.

Short-term gains include gains the fund realizes on securities held for one year or less; they are ordinary dividend distributions.  Long-term gains include the realized gains held for more than one year.  Mutual funds reduce long-term gains by the capital losses.  Distributing any remaining amount fund shareholders on a per-share basis.  You can choose to receive distributions directly in cash.  But most investors choose to have their distributions reinvested (so they buy additional shares of the fund).

These capital gains distributions are the result of the fund selling shares in stocks that have appreciated.  If the fund manager decides to sell a stock due to the changing outlook for the stock, or even if the fund must simply raise cash for shareholder redemptions (if a shareholder sells shares of the fund), if the stock is trading higher than when the fund initially purchased it, the fund must distribute at least 95% of the gains to shareholders.


What Is the Economic Value of the Distribution?

It might seem positive to receive a capital gains distribution.  However, there is actually no positive economic value to the distribution.

For instance, looking further at the XYZ Mutual Fund distribution:

  • You own 1,000 shares of the XYZ Mutual Fund.  The fund has a net asset value (NAV) of $10 per share.  Your investment in the fund equals $10,000.
  • The total value of your holding in the fund is $10,000 (1,000 shares at $10 per share) and you reinvest all capital gains and dividends.
  • The fund distributes long-term capital gains for this year.  The long-term capital gain upon the sale of stock is for example 10% of the fund’s total net asset value or $1 per share.
  • Shareholders of record on the record date will receive $1 for each share they own and the NAV (Net asset value) of the fund will be reduced by $1 on the ex-dividend date.
  • You receive $1,000, which is automatically reinvested in the fund.
  • Assuming no change in the market value, you still own $10,000 of the fund but the share price is lower which many times is confusing to many.
    • How? The fund’s NAV was reduced to $9 by the capital gains distribution of $1 and you reinvested the gain to give you a total of 1,111.11 shares ($1,000 reinvested in at the new NAV of $9 buys 111.11 shares).  If you did not reinvest the gain, you would have 1,000 shares at $9 and $1,000 cash.  Either way, you have $10,000.

Typically, we see these distributions in November to December.  This is why you need to understand how capital gains affect your funds and how companies deal with distributions and share prices.

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