If you’re someone who keeps a close eye on your investments, you may have noticed what looks like extra dividends in your account at the end of the year. Conversely, you may have noticed the value of a fund in your account mysteriously “dropping”. What’s actually happening is something called capital gains distributions and it’s important to understand how they work especially if you maintain a taxable account.
How It Works
During the year the funds in your account are hard at work (or should be if they’re good funds) trading in and out of different securities to help your account make money. When these funds sell securities they recognize capital gains just like you would if you sold a position in your taxable account (if this concept sounds foreign, check out this article we wrote about the different types of taxes). At the end of the year, the fund then distributes these gains to your account either in the form of cash or in the form of a reinvestment (the cash is used to buy more of the original investment). When this happens the value of your investment drops by the amount of cash you receive as a distribution; however, because the cash is still in your account you aren’t actually losing money and if your distribution is reinvested the value of the position will likely remain unchanged.
What Are the Tax Implications?
Capital gains distributions from funds in your account are taxable to you if they occur in a taxable account. The amount of tax you pay depends on your tax bracket. Luckily, these gains can be mitigated with efficient tax management such as tax loss harvesting. A final note when it comes to capital gains distributions is that it’s usually a good idea to wait until after a distribution has occurred to buy a fund. Otherwise, you’ll receive the distribution and have to pay taxes on it but you would have missed out on the growth that preceded it. If you’d like to learn more about tax-efficient investing or simply have questions about capital gains distributions, please don’t hesitate to shoot us an email or give us a call. We’re always happy to talk.