Capital gains explained
Mutual funds pool securities, like stocks and bonds, into 1 investment that usually centers on a common theme. A fund realizes a capital gain every time it sells a security for more than its purchase price. (A capital loss occurs when a fund sells a security for less than it paid for it.)
At the end of the year, funds could have 2 types of capital gains distributions:
- Short-term gains: gains the fund realizes on securities held for 1 year or less, which are treated as ordinary dividends.
- Long-term gains: gains the fund realizes on securities held for more than 1 year, which are treated as long-term capital gains.
You can get those distributions directly in cash. But most investors choose to have their distributions reinvested to buy additional shares of the fund.
“Reinvesting capital gains is an easy way to keep investing and allows you to take advantage of the compounding effect, where your earnings can earn more earnings,” said Chuck Riley, a financial planner with Vanguard Personal Advisor Services®.
Keep in mind that when a fund issues a distribution, its net asset value (NAV) often goes down. However, if you’re reinvesting your dividends, your account balance won’t change.
You don’t need to report any capital gains distributions for funds you hold in a tax-advantaged account, such as a traditional or Roth IRA, a health savings account (HSA), or an employer-sponsored plan.
“One of the benefits of these accounts is their ability to allow earnings, including capital gains, to grow tax-deferred and perhaps tax-free,” said Jacklin Youssef, a tax expert with Vanguard Personal Advisor Services.
If a fund you hold in a taxable account distributes a capital gain, you need to report it on your tax return. How those capital gains distributions are taxed depends on 2 things:
- The length of time the fund held the investment (either short- or long-term).
- Your individual marginal tax bracket.
Tax rates on long-term capital gains are generally lower than those on short-term capital gains.
Short-term capital gains distributions are treated as ordinary dividends and are taxed at ordinary income tax rates, typically anywhere from 10%–39.6%. If you’re in the 10% or 15% tax bracket, you may not owe tax on capital gains from securities you’ve held long-term, including mutual fund shares. (For 2017, long-term capital gains rates on other tax brackets can be as high as 20% and may also be subject to the 3.8% Medicare surtax above a certain income threshold.)
And if your fund sells some securities at a loss, it may not be all bad news.
“Investment losses, while unpleasant, can be used to lower your overall capital gains tax. All your capital losses on investments can offset your capital gains and up to $3,000 of your ordinary income, reducing or possibly even erasing the amount you’ll owe the IRS,” Riley said. “Ironically enough, I’ve found that clients are sometimes happier when their investments have lost money, because they don’t have to pay any taxes, but that’s counterproductive to successful investing. Being able to offset gains and some ordinary income is the only silver lining of losses.”
Get more information on capital gains and losses
The basics of basis
Another term you need to know when calculating your investment gains or losses is “cost basis.” Cost basis, or basis, is essentially what you paid to buy an investment.
Let’s say you purchase a mutual fund share for $5. That means your original basis is $5.
However, reinvested capital gains distributions get added to your basis. If, for example, your fund had a $0.10 distribution at year-end, your basis would be $5.10 per share. So if you sold your fund at a future date for $6, you’d report a capital gain of $0.90 instead of $1.
4 strategies to minimize capital gains taxes
- “Location, location, location.” This real estate adage applies to investing too.
“Holding tax-efficient investments, like index funds, in taxable accounts and tax-inefficient investments, like bonds, in tax-advantaged accounts is one of our core recommendations,” said Riley. “And honestly, it’s one of the most common things I see investors who manage their own portfolios not doing.”
- Take the long view. Riley also suggests you consider holding your investment for longer than a year.
“Long-term capital gains tax rates are lower than short-term ones, which helps lower the tax impact and maximizes your potential after-tax returns,” he said.
- Don’t “buy the distribution.” You may also want to hold off buying a fund in a taxable account until after it makes a distribution. If you buy a fund just before a distribution, you won’t have the benefit of a full year’s investment time, but you’ll owe additional taxes on the full distribution amount.
The opposite goes for selling a fund. If you’re considering selling, you may want to sell before the distribution date.
- “Harvest” some investment losses. If you’re going to have some realized gains, you can intentionally sell shares of funds or stocks at a loss to lower your tax burden. This is known as “tax-loss harvesting.”*
This strategy has some rules and recordkeeping requirements, so you may want to consult with a tax advisor before beginning.
While no one especially likes paying taxes, it’s almost impossible to invest wisely without having some tax impact. “There’s never any need to pay more taxes than absolutely necessary. And being tax-wise can help increase your chances of achieving your long-term goals,” said Riley.
*Tax-loss harvesting involves certain risks, including, among others, the risk that the new investment could perform worse than the original investment and that transaction costs could offset the tax benefit. There may also be unintended tax implications. We recommend that you consult a tax advisor before taking action.
All investing is subject to risk, including the possible loss of the money you invest.
This article is for educational purposes only. We recommend that you consult an independent professional tax or financial advisor for specific advice.
Advice services are provided by Vanguard Advisers, Inc., a registered investment advisor, or by Vanguard National Trust Company, a federally chartered, limited-purpose trust company.