Capital gains distributions
Question: What are capital gains?
Answer: A capital gain is the difference in value between your cost basis in an investment and its current price. (If the price is lower than what it cost you, that’s a capital loss.) You realize the capital gain once the investment is sold. Realized capital gains have tax impacts if the investments sold are owned outside the shelter of a qualified account like an IRA or a 401(k).
Q: How do capital gains occur?
A: When you sell a fund for greater than its basis, a gain will result. But aside from you or your advisor selling investments, you can also be subjected to involuntary capital gains from portfolio managers selling stock inside the mutual funds you own. By law, mutual funds must share the profits and losses from these transactions with their shareholders.
So, depending on your percentage of ownership, the mutual fund will pass on to you your portion of the net gains from those transactions. They notify you in a Form 1099, typically sent out in the first quarter of the year.
Q: What do these taxes look like?
A: It depends.
Short-term gains come from positions held by the mutual fund for less than a year. They are counted as ordinary income, so they’re added in with the rest of your income to be considered for taxes.
Long-term gains are from sales of investments held in the fund longer than a year. They can be taxed at a separate capital gains rate that starts at 15%. However, if you are in the 15% income tax bracket or lower, you may owe nothing on those gains.
Bear in mind, though, that if your income comes close to the high threshold for the 15% bracket, additional income from capital gains could push you into the next bracket, in which case, you would be subject to the extra tax on capital gains.
Q: So how do investors prepare for those gains that are out of their control?
A: Each year, prior to year end, fund companies will report the expected gains on funds, if there are any to pass along. You can go to the website of most fund families and search for “2016 capital gains” to find a list of which funds are expected to distribute gains.
You should see a record date. Investors who own shares of that fund on that date are the fund holders who can expect to receive some of the capital gains distributions.
The mutual fund websites do not make calculations for you. That’s where an advisor can assist. Generally, we reach out to clients we believe may be more significantly impacted. Otherwise, if you know your cost basis and the number of shares you hold, you can get an idea of how much of a capital gain to expect.
Q: What should I do if it looks like I’ve got capital gains coming?
A: What, if anything, to do about possible capital gains is a matter to discuss with your investment advisor and a qualified tax professional.
Capital gains are the result of your investments growing in value. Although it is prudent to minimize or offset taxes to help keep your investment costs low, be careful not to let short-term tax concerns overrule what is best for your long-term investment plans.
Tom Pappenfus is a registered representative and investment advisor at Landaas & Company.
More information Ron Hansen talks about Mutual Fund Distributions in a two-part Money Talk Video FAQ About Taxation for Mutual Fund Investors, Investment Company Institute IRS Publication 550, Investment Income and Expenses
(initially posted Nov. 25, 2014; revised Dec. 3, 2015, and Nov. 22, 2016)