What are they and how are they generated?
Capital gain distributions occur when mutual funds sell some of their underlying holdings at a profit. The capital gains generated from these sales are nearly all passed on to the fund's investors, since fund companies have an Internal Revenue Code (IRC) requirement to pay out at least 90% of their income and realized capital gains each year to their investors.
Why do fund managers sell appreciated securities that create capital gain distributions?
Fund managers might sell some of their holdings because the stocks no longer meet their investment criteria. In actively managed funds, this could happen when a stock or bond reaches a price where the manager believes the security to be overvalued. Additionally, if investors in a mutual fund sell a lot of shares of the fund, the managers may need to sell holdings to meet those redemption requests, which could trigger capital gains.
But I don't own actively managed mutual funds. Should I not expect distributions?
It's true that index funds are often more tax efficient than actively managed funds, but they still might pay out distributions. For example, a fund that tracks a small cap index may be forced to sell shares of a company that has grown so much that it no longer qualifies for that index. If the stock leaves the index, the fund also needs to sell its shares of that stock to continue tracking the index appropriately.
Are capital gain distributions good or bad?
Both. In general, capital gain distributions are a good thing, because at some level it means that a fund made money on an investment.
In taxable accounts, however, distributions mean that shareholders of the mutual fund will see an increase in their tax bill, due to the fund passing along the capital gains. If your IRA or workplace retirement plan owns funds that make capital gains distributions, there's no tax impact, due to the tax-deferred nature of these kinds of accounts.
What can be done to minimize the tax impact of capital gain distributions?
Start with "Asset Location": where you own certain types of funds (in terms of account types) can be as important as which types of funds to own. For example, in taxable accounts, we try not to own funds that tend to pay capital gains distributions. Instead, we look to buy those funds in IRAs and Roth IRAs, to maintain overall tax efficiency.
Second, think about the timing of purchases. Avoid sizable purchases right before a distribution, which typically happens towards the end of the year.
Lastly, in some instances, investors may own funds that are scheduled to make distributions, but the fund is worth less than what the investor originally paid. In that case, it may make sense to sell the fund, take the loss, and avoid the taxable distribution. The investor can then buy the fund back after 30 days to avoid wash sale rules, which would disqualify the loss. With equity markets hovering at all-time highs, however, this option is not as viable as in previous years.
