Do You Pay Capital Gains on Mutual Funds Even if You Don’t Sell Any Funds?

Written by James Hirby | Fact checked by The Law Dictionary staff |  

Investing in mutual funds has plenty of advantages. For starters, mutual funds aren't self-directed investments. They're managed by competent and well-trained fund managers who command hefty salaries for their expertise. When you purchase a mutual fund, you can rest easy with the knowledge that your fund manager will work 50 or 60 hours per week to find solid new investments, make trades and plot future profit-maximizing strategies. Meanwhile, you can concentrate on your own work obligations and forget about studying your investments at the end of a long day. In exchange for the management fee that you pay to your mutual fund's issuer, you won't have to worry about its performance. If your fund appears to be under-performing its peers, you can sell it with relative ease and buy into a new one.

Unfortunately, the tax implications of mutual fund investments aren't so straightforward. In some ways, mutual funds' tax implications are more complex than those of stocks or bonds. At issue is the difference between capital gains, dividends, distributions and sales. These four concepts can create tax-related headaches for novice investors.

For starters, the dividends that are thrown off by a given fund's stocks are taxed as regular income. Although these dividends are bundled into the quarterly or annual distributions that virtually all mutual fund issuers make, they are deemed to be separate from the capital gains that may be included in these distributions. When you receive your account statement or distribution check, you'll be able to see an exact accounting of the value of the dividends that your fund accrued.

You'll also be able to see an accounting of the value of your fund's capital gains. These gains are generated by sales of the component stocks and commodities that comprise a fund. Such gains are taxed at special rates that fluctuate from year to year.

It's important to note that mutual fund distributions are issued on a "pro rata" basis. In other words, your personal distribution will be proportional to the size of your ownership stake in the fund. If you own 5 percent of the fund's outstanding shares, your distribution will account for 5 percent of the fund's capital gains and dividends during the distribution period. Regardless of when you purchase a fund's shares, you'll pay taxes on these distributions on a "pro rata" basis as well. As such, you should wait to purchase new shares until shortly after your fund issues a distribution.

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