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How Capital Gains Distributions Work

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How Capital Gains Distribution Works

During tax season, did you receive a 1099-DIV form that showed you received a capital gains distribution? If so, you may owe taxes on the money. A capital gains distribution is a payment from a mutual fund or ETF for a portion of proceeds when assets are sold. Let’s take a closer look at capital gains distributions, how they’re taxed and some strategies to avoid or minimize taxes on them in the future.

For proper tax planning, consider working with a financial advisor who specializes in tax.

What Are Capital Gains Distributions?

A capital gains distribution is defined by the IRS as a payment from a mutual fund or an exchange-traded fund (ETF) when a security or stock is sold at a profit. Because these types of funds are generally pools of different investments, the fund managers may sell some of these underlying investments and pass along a portion of the profits to you.

Capital gains distributions usually are sent out at the end of the tax year, at which point you can choose to either reinvest the payout in the fund or take it as cash — the IRS considers it income either way.

How Capital Gains Distributions Are Taxed

How Capital Gains Distribution Works

Whether an investment was held for less than a year (short-term capital gain) or more than a year (long-term capital gain), distributions from mutual funds and ETFs are taxed at the more favorable long-term capital gains rate.

Capital gains distributions are taxed at rates of 0%, 15% or 20%, depending on income. Let’s look at how the rates break down in 2023:

RateSingleMarried Filing JointlyMarried Filing SeparatelyHead of Household
0%$0 – $44,625$0  – $89,250$0 – $44,625$0 – $59,750
15%$44,626 – $492,300$89,251 – $553,850$44,625 – $276,900$59,751 – $523,050
20%$492,300+$553,850+$276,900+$523,050+

For comparison, here are the long-term capital gains tax rates for 2022:

RateSingleMarried Filing JointlyMarried Filing SeparatelyHead of Household
0%$0 – $41,675$0  – $83,350$0 – $41,675$0 – $55,800
15%$41,676 – $459,750$83,351 – $517,200$41,676 – $258,600$55,801– $488,500
20%$459,750+$517,200+$258,600+$488,500+

Generally, you’ll owe taxes on the distribution for the year you received them, unless the distribution comes from a fund owned inside a 401(k), IRA, or another tax-deferred retirement plan. Then, you’ll owe the taxes for the year in which you withdraw the funds.

What This Means for You

How Capital Gains Distribution Works

While seeing profit from your investments is a great thing, it’s clear that the tax treatment can get complicated. You can try to avoid capital gains distributions — and thus the tax complications — by investing in tax-efficient ETFs, which rarely sell holdings. You could also lower your overall tax liability with tax-loss harvesting, a strategy that lowers your tax bill using the money you’ve lost on investments to offset your profits. When you write off your losses, you are able to cancel out some (or all) of your gains, thus reducing your tax bill.

You could also work with a financial advisor to navigate the tax impacts of capital gains distributions. A financial advisor can not only help you file your taxes correctly, they can also help you find tax savings you might not know about. Expert advice can make all the difference if you feel a little out of your depth dealing with the nuances of capital gains distributions.

Bottom Line

A capital gains distribution is the payment that a mutual fund or ETF makes to investors when one of the fund’s underlying investments is sold at a profit. Capital gains distributions are typically sent out at the end of the tax year. You can either cash out those profits or reinvest them in the mutual fund or ETF. Either way, the IRS considers it income and will expect you to pay taxes on the money.

Tips for Tax Planning

  • For many investors, mutual funds are an excellent way to balance diversification with gains. If you need help selecting mutual funds or other tax-efficient investments, consider working with a financial advisor. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • Use our capital gains tax calculator to estimate how much you’ll owe in taxes on your investments. Meanwhile, our income tax calculator can give you a fuller picture of your tax situation in a given year.

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