What is a 'Capital Gains Distribution'
A capital gains distribution is a payment to shareholders that is prompted by a fund manager's liquidation of underlying stocks and securities in a mutual fund, or derived from dividend and interest earned by the fund's holdings minus the fund's operating expenses. Capital gains distributions must be made by a mutual fund manager because tax law dictates that substantial portion of investment income and capital gains must be paid to investors.
BREAKING DOWN 'Capital Gains Distribution'Capital gains distributions are taxed at capital gains rates to the person receiving the distribution. Holders of mutual fund shares are required to pay capital gains tax on any capital gains distributions made by the funds they own. Before 1986, all mutual fund shareholders were charged long-term capital gains on distributions, regardless of how long they held the funds. With the passing of the 1986 Tax Reform Act, shareholders now pay long- or short-term capital gains tax based on the time they've owned the fund.
Capital Gains Distribution Example
Assume that an investor owns 2,000 shares of a mutual fund that has five million total shares outstanding. During the year, the mutual fund realized $15 million in total capital gains from the sale of stock positions in its portfolio. Of that total gain, 80% are long-term capital gains and 20% are short-term capital gains. In this scenario, the fund would distribute the following amounts to this particular investor:
Long-term capital gain distribution to investor = $15,000,000 x 80% x (2,000 / 5,000,000) = $4,800
Short-term capital gain distribution to investor = $15,000,000 x 20% x (2,000 / 5,000,000) = $1,200
If the investor was in the highest marginal tax bracket, 39.6%, he would then be required to pay 20% tax on the long-term distribution and 39.6% tax on the short-term distribution:
Long-term capital gains tax due = $4,800 x 20% = $960
Short-term capital gains tax due = $1,200 x 39.6% = $475.20
Regardless how long the investor owned the fund, the distributions are taxed based on how long the fund itself held the sold holdings. For example, if the investor in the example above only held the fund two months, he would not pay short-term capital gains tax on all of the distribution, rather he would pay the long-term and short-term taxes based on how long the fund held the stocks.
Capital gains distributions may occur even if a fund's price has dropped during the year. For example, a fund may have sold some stocks that appreciated in price since the fund purchased them, but these gains may be outweighed by a larger group of stocks that experienced recent price declines. The overall net effect can be a lower net asset value.