What Does Reinvesting Capital Gains Mean?

You can take investment earnings in cash, or reinvest them.

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When taking a profit on the sale of an investment, or property, you have an important decision to make: what to do with the gain. Although there will be multiple options, the first and most basic decision is to either reinvest or not. No matter which way you go, and how much you've earned, there will be tax implications.

Mutual Fund Capital Gains

A mutual fund is a portfolio of diverse investments that a professional manager buys and sells. Instead of buying stocks or bonds individually, you buy shares in the entire portfolio. At the end of the year, the fund calculates the sum total of these wins and losses, and announces the net capital gain for the year, per share. The fund will distribute the profit (if any), as well as any dividends earned on its investments. Investors can take the distribution in cash, or reinvest the money into more shares of the fund. Long-term fund investors prefer reinvesting capital gains, which allows them to more rapidly accumulate shares over the years.

Stocks and Cash

With individual stocks, you have a similar decision to make if you sell the shares for a profit. A reinvestment of the gain when the shares fall in price would allow you to own more shares of the stock -- a good strategy if you believe the investment remains a smart one. However, if you're negative on the stock and on the market as a whole, you can reinvest the money in a more conservative way: by saving the cash in a bank account, for example, or buying shares in a money-market fund, which pays a stable rate of interest.

Real Estate

Selling your home, even in a down market, might result in a taxable capital gain. Once upon a time, the IRS allowed you to avoid this levy by reinvesting the gain in a more-expensive home. But new tax rules on home sales now require only that the seller live in the home for two years out of the past five. If you meet that test, you are not required to reinvest in a new home, and can exclude up to $250,000 in gains ($500,000 for a couple filing a married, joint return).

Reinvestment, Taxes and IRAs

The Internal Revenue Service taxes capital gains on investments, whether you reinvest them or not. You must declare these gains on Schedule D of your Form 1040 and pay tax on the gain. If you've held the investment for more than a year, you pay at the higher long-term rate; short-term capital gains taxes are for investments held less than a year. If you have the money invested in a tax-deferred savings vehicle such as a traditional IRA, the gains continue to add up until you start making (taxable) withdrawals. In a Roth IRA, investment gains are tax-free when you start withdrawing.