When you sell an investment for a profit, you are typically required to pay capital gains tax on it. For stocks, you will pay tax on the difference between the price you bought at (cost basis) and the price you sold at. Calculating this figure becomes complicated for mutual funds, especially those you have invested in for a long time, because the fund managers buy and sell securities in the fund’s portfolio. You will have a different cost basis for your initial investment, for any additional investments, and for any purchases made through reinvested dividends.
How Mutual Fund Distributions Work
Mutual funds often sell profitable investments at certain times during the year. They then distribute the profits to shareholders in the form of capital gains distributions.
Capital gains distributions are reported on Form 1099-DIV, which shows cash distributions and capital gains distributions paid throughout the year. They are taxed at long-term capital gains tax rates regardless of how long you have held the shares within the fund.
Note: Long-term rates often apply to assets you have held for more than a year. They are more favorable than short-term rates.
Capital gains distributions can be reported directly on Form 1040 if you do not have other capital gains to report. Otherwise, they are reported on Schedule D along with your other gains and losses.
Accounting for Capital Gains Distributions
When it comes to calculating your capital gain or loss, you must do this for each share in the mutual fund you sell. This is where it becomes complicated, as you have a different cost basis and holding period for each share if you have invested in the fund over time.
The IRS allows you to choose one of three different accounting methods to calculate your gain. You may want to calculate all three methods in a trial scenario to determine which one is most beneficial for you.
The allowed accounting methods are:
- Actual cost basis using specific identification
- Actual cost basis using FIFO (First In, First Out)
- Average cost basis, single category method
Note: You must stick to this method for the specific mutual fund when using a certain accounting method to file your tax return. You are bound, at least for that fund. However, you can choose different accounting methods for each mutual fund you own.
Reinvested Earnings and Capital Gains Distributions
Many investors choose to reinvest the earnings received from mutual funds. Each reinvestment is counted as a cash distribution and an additional purchase of the fund. Both dividends and capital gains distributions are included in taxable income.
Note: The additional shares purchased through reinvestment have their own cost basis, which is the purchase price of the shares, and their own holding period.
For example, you invested $1,000 in a mutual fund that does not pay dividends. After one year, your investments in XYZ increased to $1,500 due to market gains. Since you invested $1,000 and received no dividends, your cost basis for XYZ is $1,000. Based on that, your capital gain is $500 ($1,500 – $1,000) and you will pay capital gains tax on it.
Now, let’s say you invested that $1,000 in fund ABC that pays dividends, and during the year the fund paid $500 in dividends which you reinvested as a purchase of more shares in ABC. Your investments would still total $1,500 by the end of the year, but the cost basis for ABC would increase to $1,500 because the dividends were used to buy more shares in the fund and would be treated as an investment.
Questions
Frequently Asked Questions (FAQs)
What tax do I pay on capital gains distributions from mutual funds?
When fund managers buy and sell securities in a mutual fund portfolio and realize profits, they share those profits with the investors in the fund in the form of capital gains distributions. Capital gains distributions from mutual funds are taxed at long-term capital gains tax rates regardless of how long you have owned the shares of the mutual fund.
How do capital gains distributions from mutual funds affect the cost basis?
Capital gains distributions can increase the cost basis if you reinvest them in the fund. If you purchased shares in a mutual fund for $100 that does not pay dividends, your cost basis will be $100 and will be used to determine any capital gain or loss when you sell the fund’s shares. If you invested $100 in a fund that pays dividends and reinvested $20 you received as distributions in the year, the purchase of the additional shares will be treated like any other investment. This means your cost basis will increase to $120.
Sources:
IRS. “Topic No. 404 Dividends.”
IRS. “About Schedule D (Form 1040), Capital Gains and Losses.”
IRS. “Publication 550, Investment Income and Expenses- Special Rules for Mutual Funds.”
IRS. “Mutual Funds (Costs, Distributions, Etc.)”
Columbia Threadneedle Investments. “Cost Basis FAQs,” Page 4.
Vanguard. “Cost basis doesn’t equal performance.”
Source: https://www.thebalancemoney.com/mutual-funds-and-capital-gains-3192975
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