While most people are painfully aware of short-term capital gains, short-term capital gains distributions are often a misunderstood -- and always a dreaded -- aspect of mutual fund investing. Financial advisors, sophisticated investors and novices alike, forget the rules of the unpleasant feature of mutual funds we know as short-term capital gains distributions.Why are these short-term capital gains distributions so much worse than short-term capital gains? Short-term capital gains distributions are considered ordinary income and, unlike short-term capital gains, cannot be offset by capital losses. Let's take a closer look.
What Are Capital Gains Distributions?
Each year, mutual fund shareholders face the prospect of receiving capital gains distributions from their mutual funds. These capital gains distributions are the result of the mutual fund selling securities within the fund. For instance, if a mutual fund sells its General Electric holdings, it is forced to distribute 95% of the gain on that sale to fund shareholders.
Unless your mutual fund is held in a tax-deferred account (e.g., 401k, 403b, IRA), fund shareholders must pay tax on these distributions.
Long vs. Short-Term Capital Gains Distributions
If a mutual fund sells the shares it has owned for 12-months or fewer, any gains as a result of that sale are considered "short-term capital gains" and are distributed to shareholders as short-term capital gains distributions. If, however, a mutual fund sells shares that it has owned for more than 12 months, any gains as a result of the sale are classified as "long-term capital gains" and are distributed as long-term capital gains distributions.
This makes perfect sense, but what you might not realize is that shareholders may face both long-term and short-term capital gains distributions as a result of owning shares in a particular mutual fund, regardless of how long you have owned shares in the fund. Remember, the applicable timeframe is based on the mutual fund's holding period for the securities within the mutual fund, not how long the mutual fund's shareholder has held the mutual fund itself.
Why All the Fuss about Short-Term Capital Gains Distributions?
The difference between short-term capital gains and short-term capital gains distributions is what causes all the fuss and confusion. For instance, if you own a mutual fund for a few months and then sell out for a gain, you have incurred a short-term capital gain. If you don't have enough losses to offset this gain, the net result is a short-term gain and you will have to pay ordinary income tax rates on the amount of money you made as a result of the sale. In this scenario in which you gained from buying and selling shares in the mutual fund, you are able to use any short-term gains you might realize against other capital losses to reduce your tax liability.
That's important to know because it isn't quite the case when it comes to short-term capital gains distributions from a mutual fund. Instead, if you own a mutual fund that subjects you to short-term capital gains distributions, then you must report them on your tax return as ordinary income. Unlike short-term capital gains, capital losses do not offset short-term capital gains distributions and reduce your tax liability.
Again, Why the Fuss about Short-Term Capital Gains Distributions?
Still not convinced that this confusion about short-term capital gains versus short-term capital gains distributions matters much? Think of it this way -- it might quickly become a problem to the extent that you had planned to reduce your tax bill using tax-loss harvesting strategies.
If you or your financial advisor believes that short-term capital gains distributions are just like short-term capital gains, then you might be unpleasantly surprised at tax time, when you owe more in taxes than you planned.