When an investor sells a capital asset — such as a stock or a bond — for more than the purchase price, the investor experiences a capital gain, or, in other words, makes a profit. For example, if a stock is purchased for $100 and later sold for $120, the capital gain is $20.
When a mutual fund sells securities at a profit, the sale also creates a capital gain. There are two types of capital gains — short-term and long-term. Net short-term capital gains are distributed to investors as income dividends and are subject to ordinary income taxes. The maximum tax rate on long-term capital gain distributions is 20%. This rate does not include the 3.8% surtax applicable to net investment income for higher income taxpayers.
When a mutual fund sells a holding, it receives any profit, or capital gain, that results from the sale. Mutual funds are required by law to distribute virtually all gains to their shareholders in capital gain distributions. These distributions, which often occur once or twice a year, are made primarily for tax reasons.
Fund managers buy and sell securities throughout the year, sometimes at a profit, sometimes at a loss. When profits outweigh losses, they accumulate and contribute to the rise of the net asset value (NAV), or share price, of the fund’s shares. When that profit is paid out to shareholders as a capital gain distribution, its NAV will be reduced by the amount of the distribution.
However, this doesn’t mean that investors are losing money. Investors can either take capital gain distributions in cash or reinvest them, as most investors do. If capital gains are reinvested, the number of shares in the account will increase, leaving the total value of the account unaffected by the distribution.