CGV Basics – Beginners Should Start Here

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This site is designed primarily for educated investors. If you are new to the concept of capital gains and capital gains distributions, I’ve put together some FAQs below. If you are looking for a “starter” resource- check out the book “Common Sense on Mutual Funds” by John Bogle.

Q: What is a mutual fund capital gain distribution?

Simply put, a capital gain results when we buy low, then sell high. Capital losses are the opposite.

Mutual funds buy/sell holdings and (hopefully) create capital gains. Since mutual funds are not tax-paying entities- they are forced to distribute a substantial portion of these gains to their investors annually. Most mutual funds make these capital gains distributions in November or December of each year. For investors using mutual funds outside of tax-deferred accounts- it’s important to be aware of these distributions as they are considered taxable income.

Q: Are there any good primers on mutual fund taxation?

Yes! I really like the coverage that can be found at Fairmark.com’s Tax Guide on Mutual Fund Taxation.

Q: When can I ignore these distributions?

There are several situations where these capital gains distributions aren’t an issue (or a big issue):

  • you are very wealthy and enjoy paying taxes
  • you are investing funds in tax-deferred accounts (your IRA, Roth IRA, variable annuity, 401(k) plan, etc.)
  • you are making a small purchase or own a relatively small position – even a 20% distribution on a $500 purchase will only change this year’s taxes by $15-$35
  • you are in the lowest tax brackets and your fund is making long-term capital gains distributions (in some situations, these can be taxed at 0%)
  • you have loss carryforwards, and your fund is making long-term capital gains distributions

Q: How are these distributions taxed?

There are several types of mutual fund distributions and they each have different tax implications. Remember: these only matter in “taxable” accounts. The most common distributions are:

  • qualified dividends – these are taxed at preferential capital gains rates (0%, 15% or 20%)
  • ordinary dividends – these are taxed at your ordinary income rate (10%, 12%, 22%, 24%, 32%, 35%, 37%)
  • short-term capital gains – these are taxed at your ordinary income rate
  • long-term capital gains – these are taxed at preferential capital gains rate

For a more detailed overview, take a look at Fairmark.com’s Tax Guide on Mutual Funds.

Q: What are the key dates I need to pay attention to?

There are three key dates that apply to mutual fund distributions:

  • Record Date: If you own shares on this day then you are eligible to receive the distribution.
  • Ex-Dividend Date: The date when the distribution amount is deducted from the fund’s net asset value per share. Generally, this is the next business day after the record date.
  • Payment Date: Shareholders get their proportional shares on this date. This is typically the same business day as the ex-dividend date.

Q: I own the fund in my IRA; isn’t a huge distribution a good thing?

Capital gains distributions are economically neutral for tax-deferred investors. The key issue is that the fund will reduce its Net Asset Value (NAV) on the distribution date by the distribution amount.

Example 1: Chris owns $20,000 of ABC Fund in his IRA. The fund makes a 10% long-term capital gain distribution and Chris does not reinvest his distributions. The result: Chris’ account receives $2,000 in cash. He owns the same number of shares, but at a 10% reduction in NAV. He therefore has $2,000 plus $18,000 of ABC Fund.

Example 2: Chris owns $20,000 of ABC Fund in his IRA. The fund makes a 10% long-term capital gain distribution and Chris reinvests his distributions. The result: Chris’ $2,000 buys additional shares of the newly-discounted fund. He owns more shares; but since the NAV dropped by the same amount Chris still owns $20,000 of ABC Fund.

Q: I am reinvesting my dividends, am I taxed anyway?

Yes – taxes are due on distributed amounts no matter what you do with the proceeds.

Q: Do I need to worry about the wash sale rules?

Wash sale rules are a very important consideration when dealing with capital gains strategies. Basically, you are not allowed to claim a loss if you sell your holding at a loss and buy “substantially identical securities” within the 30 days before or after the sale. Fairmark.com’s Tax Guide on Wash Sales is an excellent source for additional information on this topic.

Q: How do I control future capital gains distributions?

Capital gains distributions are beyond the control of the shareholders. Actively managed mutual funds are typically the worst offenders when it comes to annual distributions. Even “tax-managed” funds and many of the more unusual index funds can make substantial fund distributions. To keep more of your gains in your pocket:

  • pay attention to capital gains distributions and make smart trades when these are substantial
  • think about your asset location (putting tax-inefficient funds in your IRAs and your tax-efficient holdings in your taxable account)
  • use market-cap weighted strategies (especially ETFs) as your core holdings in your taxable accounts, and perhaps as your only holdings in these accounts

 

 

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