Plan Ahead Using Capital Gain Distribution Estimates
Each year, mutual funds are required to distribute 95% of the net capital gains generated in their portfolios. For instance, if a mutual fund owned XYZ stock and sold it for a gain in the current calendar year, the mutual fund would be required to pass any capital gain it realizes to its shareholders.
To help shareholders prepare for capital gain distributions, mutual fund companies generally post capital gain distribution estimates beginning in October. These capital gain distribution estimates can help mutual fund investors (who own funds held in taxable accounts) plan ahead for tax day.
Plan Ahead -- Capital Gain Distribution Estimates
In order to plan ahead using capital gain distribution estimates, it is important to understand the different types of capital gain distributions. Contrary to popular belief, long-term capital gain distributions and short-term capital gain distributions from mutual funds are not treated the same as typical capital gains and losses (such as realized gains and losses from the sale of a security) on your tax returns. For this reason, it is important to plan ahead by reviewing the capital gain distribution estimates of any mutual fund you hold.
Let's take a look at an example of the different tax treatment of long-term and short-term capital gain distributions.
Investor Jack's Scenario:
- Investor Jack holds Mutual Fund A and Stock XYZ.
- Mutual Fund A distributed a long-term capital gain of $1,000 to Investor Jack.
- Investor Jack sold Stock B, realizing a $1,000 capital loss.
- Result: The $1,000 loss is netted against the fund's $1,000 long-term capital gain distribution and the result is no tax liability for Investor Jack.
Investor John's Scenario:
- Investor John holds Mutual Fund B and Stock XYZ.
- Mutual Fund B distributed a short-term capital gain of $1,000 to Investor John.
- Investor John sold Stock B, realizing a $1,000 capital loss.
- Result: The $1,000 loss cannot be netted against the fund's $1,000 short-term capital gain distribution and results in a $1,000 increase in Investor John's ordinary income.
Look closely at the difference in the two scenarios. The difference in the two scenarios is that Investor Jack had a long-term capital gain distribution and Investor John had a short-term capital gain distribution. The holding period (short-term or long-term) of Stock B is irrelevant in both scenarios. Short-term capital gain distributions are always treated as ordinary income.
Reviewing your mutual fund capital gain distribution estimates will help you know what to expect when tax day comes. It may also lead you to plan ahead; to either offset gains with losses (in Investor Jack's scenario), or avoid short-term capital gains by selling your mutual fund ahead of the distribution -- which might have helped Investor John.