Can you use distributed gains to reduce your tax burden? Capital gains distribution is defined as a payment by a mutual fund or an exchange-traded fund of a portion of the proceeds from the fund’s sales of stocks and other assets. Here’s how to use it to reduce your taxable income.
Capital Gains Distribution
Usually, an ETF or mutual fund makes a capital gains distribution at the end of each year. This represents the proceeds of the sales of stock or other assets by the fund’s managers during the tax year. Investors need to keep in mind that cashing in on the capital gains distribution instead of reinvesting it in the fund is essentially a withdrawal. This reduces the net amount you have invested in the fund by the amount of the distribution.
Tax Considerations
People who hold mutual fund shares are required to pay taxes on the capital gains distributions made by the funds they own, regardless of whether the money is reinvested in additional shares. However, there is an exception for municipal bond funds. These are tax-exempt at the federal level and usually at the state level.
If the fund is not in a retirement plan, the taxes will be due for that tax reporting period. However, if the investor owns the fund as part of an IRA, 401(k), or another tax-deferred retirement plan, the taxes are not due for that tax year. The taxes will be due when the funds are withdrawn during retirement.
IRS Regulations for Capital Gains Distribution
Current IRS regulations say that capital gains distributions from mutual funds or ETF holdings are taxed as long-term capital gains, regardless of how long the individual has owned shares of the fund. So, the tax rate will depend on the individual’s ordinary income tax rate.
Reducing Tax Burden
Individuals who wish to reduce their tax burden may consider tax-efficient investments, such as tax-efficient funds. These normally identify themselves in their descriptions. They generally sell and buy stocks less frequently than aggressive growth funds. Also, they may hold some municipal bond funds for tax-free income.
[Related: Tax-Efficient Charitable Giving]
Additionally, capital gains distributions may be made even when a fund’s overall value has dropped during the year. Meaning that the fund may have sold some stocks that had appreciated but these gains might be offset or erased by other investments that lost money.
Net Asset Value
The distribution of capital gains and dividends decreases the net asset value of the fund by the amount distributed. For example, the fund manager of a fund with a net asset value of $20 per share may pay a $6 distribution to shareholders. This would result in the fund’s NAV declining by $6, to $14.
While this appears on a mutual fund’s price chart as a decline in price on the ex-dividend date, the total return of the fund hasn’t changed. Unrealized gains on securities determine the mutual fund’s net asset value until they are sold.
Minimizing Investment Taxes
Your financial advisor can work with you to create a strategic approach to investing that will help maximize your retirement income while simultaneously minimizing your investment taxes.
Investment Tax Strategies for the Washington DC Metro
Working with a financial advisor to develop a goal-driven plan will help you make the most of your investments while also being tax-efficient. To learn more about reducing your tax burden with capital gains distributions, contact Argent Bridge Advisors today.
