There are two different types of distributions that typically come to you as an investor in a mutual fund. We’ve talked about dividends before but mostly in the context of a stock dividend. There are also dividends that are paid when you own a mutual fund and these are typically called distributions. But a distribution is not only a dividend, it can also be a capital gain.
As I said, there are two types of distributions, or cash paid back to you as the owner of the portfolio of stocks. They are dividends and capital gains. Even though you may think of a mutual fund as one unit, there are stocks in that mutual fund that make up the overall performance of the fund. There are some investors that do not know the difference between a dividend and a capital gain, and there are some investors that did not even know that a capital gain distribution exists, so this is what I am going to cover today.
How is a Capital Gain Different from a Dividend?
The difference between a capital gain and a dividend is pretty simple. A dividend is a planned payout that is typically created when the individual stocks in the portfolio pay dividends. The mutual fund manager will then pass these dividends onto the individual investors on a planned schedule. A capital gain is created at the point of sale. The biggest difference between the two is the way that they are taxed.
A capital gain is the profit that is realized after selling a stock. If you own individual stocks and you have ever sold any, then you have had to pay a capital gains tax. In a mutual fund you will hopefully receive dividends but you may also receive capital gains. Dividend income is typically taxed at your ordinary income tax rate and there is a different tax schedule for capital gains. When you receive a distribution, the statement will list the amount and type of distribution. It is important to look at the breakdown of the total distribution to see what portion comes from dividends and what portion comes from capital gains.
What Causes Capital Gain Distributions?
There are some mutual funds that normally pay out cash as dividends each quarter, or on a yearly schedule. There are also mutual funds that regularly pay out capital gains at the end of the year in one lump sum. Typically the capital gain is less than a dollar a unit. Sometimes there are unplanned capital gain distributions. If there are investors in the mutual fund that decide to cash out, or redeem, the mutual fund manager usually pays them with extra cash that is in the portfolio. However if the mutual fund manager does not have enough cash on hand to handle a redemption from the fund; the manager may have to sell holdings in order to satisfy that demand.
How are Capital Gains Taxed?
You will need to check with your tax attorney or tax prep agent to figure your individual tax rate; however, in general the capital gains tax is lower than your overall personal tax rate. In the US you will need to determine if the capital gains are long term or short term. In Canada, there is just one tax for all capital gains whether they are long term or short term. Capital Gains made from investments in a tax free account are not taxed. So in order to avoid paying taxes on capital gains and dividends you can purchase these passive income earners in your after tax retirement account.
Does your dividend strategy include mutual funds? If so, do you watch for capital gains?