A mutual fund does not decide whether or not it should make capital gains distributions. The rules and laws covering mutual fund management dictate the capital gains requirements, and every mutual fund has the potential to pay capital gains. The amount of any capital gains a fund pays depends on the fund's investment success and how it manages its portfolio.
As a mutual fund manager sells and buys securities for the fund's portfolio, each selling transaction results in either a capital gain or capital loss. At least once a year, funds are required to pay out the net capital gains to shareholders. Capital gains incurred during the year are reflected in the fund's share price until the capital gains distribution is paid, and then the share price declines by the amount of the gains distribution. Capital gains paid by a mutual fund are reported on a Form 1099 for an investor to include on his tax return.
Portfolio Turnover Rate
The amount of capital gains a fund distributes depends on whether the securities it owns went up in value and how often the fund manager buys and sells. If a fund holds onto stocks or bonds and doesn't sell, there will be no reportable capital gains and little or no capital gains distribution. If the fund manager does a lot of buying and selling, that trading produces capital gains that must be distributed. How much a fund manager trades in the portfolio shows up in the fund's reported turnover ratio. Different funds have ratios ranging from less than 10 percent to well over 100 percent per year.
Although net capital gains must be paid out to investors each year, net losses can be carried forward to offset gains in future years. For example, if a fund books a lot of losses during a down year in the stock market, those losses may allow the fund to not pay capital gains distribution for the next several years, even if the fund's investments go up in value. The carry forward of capital losses makes it difficult to predict how much capital gains a fund may pay in a particular year.
When to Buy Shares
Most mutual funds make capital gains distributions during the last couple of weeks of the year. You do not want to buy shares in December and then get hit with a capital gains tax bill on gains you did not really earn. When capital gains are paid, a fund's share price drops by the amount of the distribution, so an investment position stays level if the gains are reinvested. If you plan to buy into a fund late in the year, wait until after the capital gains distributions have been made.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.