Mutual funds are required to pass along to investors the gains realized from trading securities. The distributions paid can be automatically reinvested into more shares. However, the capital gains distributions your fund account earned must be reported on your taxes, whether you took the distributions in cash or had them reinvested.
Mutual Fund Capital Gains Distributions
When an investment is sold, the result is a reportable capital gain or loss. If a mutual fund produces more realized gains than losses during the year, those gains are paid out to investors as capital gains distributions. If a fund ends up with net losses, those results are carried forward and can be used to offset gains in future years. The payment of capital gains is not optional for the fund company. If the fund produced more winners than losers -- or at least sold more winners than losers -- capital gains distributions must be paid to investors.
Mutual fund capital gains distributions are taxable under the capital gains tax rules. The fund divides the gains into long- and short-term results. You pay your regular tax rate on short-term gains, and long-term profits are taxed at a lower rate. The Form 1099 from the fund shows the types of gains for your distributions. The Internal Revenue Service doesn't care what you did with the gains, including reinvestment -- it wants the taxes on these reported profits.
Increasing Cost Basis
When you reinvest mutual fund capital gains distributions, those dollars are viewed as additional investments in the fund. As a result, reinvested distributions increase your cost basis when you sell fund shares, and a higher cost means a smaller gain and fewer taxes to be paid. For example, you invested $1,000 in a mutual fund, and $100 in capital gains have been reinvested. You sell all the shares in your account for $1,250. The reinvested gains increase your cost basis to $1,100, so you declare and pay taxes on a profit of $150: $1,250 minus $1,100. Your investment produced a $250 profit, but you already paid taxes on the $100 in capital gains distributions.
If you own mutual fund shares in a tax-deferred account such as an IRA or 401(k), you will not report reinvested capital gains distributions as taxable income. The tax-advantage shell of the type of account keeps the results from the fund investments inside the retirement plan accounts from being currently taxable. Retirement plan proceeds are only taxable if you make withdrawals. In these accounts, you can let your capital gains distributions reinvest and compound for years without paying taxes on the reinvested gains.
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.