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 of 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 for 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.

Capital Gains Distributions and Net Asset Value

As is the case with common stocks, the distribution of capital gains and dividends decreases the net asset value (NAV) of the fund by the amount distributed. For instance, the fund manager of a fund with a net asset value of $20 per share may pay a $5 distribution to shareholders. This would result in the fund's net asset value declining by $5, to $15. Although this appears on a mutual fund's price chart as a decline in price on the ex-dividend date, the total return of the fund has not changed. Unrealized gains on securities determine the mutual fund's net asset value until they are sold. 

RELATED TERMS
  1. Distribution

    Distribution occurs when a mutual fund, company or retirement ...
  2. IRS Publication 564: Mutual Fund ...

    IRS Publication 564: Mutual Fund Distributions is a publication ...
  3. Long-Term Capital Gain or Loss

    A gain or loss from a qualifying investment owned for longer ...
  4. Distribution Yield

    A distribution yield is a measurement of cash flow paid by an ...
  5. NAV Return

    The NAV return is the change in the net asset value of a mutual ...
  6. Mutual Fund Timing

    Mutual fund timing is the practice of trading mutual funds according ...
Related Articles
  1. Investing

    How Tax-Efficient Is Your Mutual Fund?

    Learn about factors that influence the tax-efficiency of your mutual fund, how income from your investment is taxed and what to look for when choosing a fund.
  2. Financial Advisor

    Income tax on mutual funds: The basics

    Learn about the basics of income tax on mutual funds, including what types of income may be subject to the capital gains tax rate.
  3. Investing

    Why Some Investors Have to Pay Taxes on a Loss

    Here's why some investors need to pay capital gains taxes even if they haven't sold any funds or made any portfolio changes—and how to combat it.
  4. Investing

    Trading Mutual Funds for a Living: Is It Possible?

    Find out why trading mutual funds for a living isn't your best bet, including how funds discourage short-term trading and which options may better serve you.
  5. Financial Advisor

    After Poor Performance, Now a Mutual Fund Tax Hit?

    If the performance of mutual funds in 2014 wasn't bad enough, here comes a tax hit from liquidations.
  6. Investing

    A Guide to Mutual Funds Trading Rules

    Make sure to review this guide on the dos and don'ts of mutual fund trading before you invest, including how trades are executed and which fees to look out for.
  7. Taxes

    What You Need To Know About Capital Gains And Taxes

    Find out how your profits are taxed and what to consider when making investment decisions.
  8. Investing

    When to buy a mutual fund

    Doing a little research can help you find out if mutual funds are a good fit for your portfolio.
Hot Definitions
  1. Portfolio

    A portfolio is a grouping of financial assets such as stocks, bonds and cash equivalents, also their mutual, exchange-traded ...
  2. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
  3. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  4. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  5. Current Assets

    Current assets is a balance sheet item that represents the value of all assets that can reasonably expected to be converted ...
  6. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
Trading Center