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When an investor sells a capital asset — such as a stock or a bond — for more than the amount paid for it, the investor makes a profit, or capital gain. For example, if a stock is bought for $100 and later sold for $120, the investor’s capital gain is $20.
When a fund sells securities at a profit, the sale also creates a capital gain. Two types of capital gains are realized by our funds — short-term and long-term. Net short-term capital gains are distributed to investors as income dividends and are taxed at ordinary income tax rates. Long-term capital gain distributions are currently taxed at a maximum rate of 20%.1
When mutual funds sell securities, they typically realize gains or losses. If gains exceed losses, most funds distribute substantially all of their net gains to their investors before the end of the calendar year to satisfy federal excise tax rules. These distributions, which typically occur once or twice a year, are made primarily for tax reasons.
When the value of a fund holding increases, the fund has an unrealized gain until the security is sold. Once this security is sold, however, the fund realizes the gain and must pay a distribution unless the gain is offset by capital losses. Consequently, a fund’s capital gain distribution in a particular year is a result of the sale of securities that may have appreciated in value, perhaps during prior years when the fund’s returns were positive.
We are mindful about the taxes our investors pay on capital gain distributions. While taxes are an important consideration, meeting the funds’ investment objectives is our primary goal. Therefore, securities will typically be sold when it is deemed appropriate for investment reasons.
When gains from sales of securities outweigh losses, they accumulate and contribute to the rise of the net asset value (NAV) of the fund’s shares. When that gain is paid out to investors, its NAV, or share price, is reduced by the amount of the distribution.
Example: Say a fund share sells at an NAV of $10. If sales of the fund’s securities have resulted in the fund making a capital gain distribution of $2 a share during the year, $2 will be paid to investors on the fund’s payment date. The fund share price will decline to $8 on the record date as a result of the distribution.
The record date is the date when investors in a particular fund are entitled to receive a fund distribution.
No. Investors still have $10 in value — $8 in the fund’s NAV, and $2 in their pockets or reinvested in the fund. And if they do automatically reinvest their capital gain distributions, it buys them additional fund shares at the new, lower price of $8. These additional shares compensate for the drop in the NAV, so the total value of their accounts doesn’t change. (Of course, if there is a decline in the market at the same time, they may still see a drop in the total value of their accounts.)
Example: Let’s say there are 100 shares in an investor’s account. At an NAV of $10 a share, the account value is $1,000. If the fund pays a capital gain distribution of $2 a share, the NAV drops to $8, and the original 100 shares are now worth $800. If capital gain distributions are reinvested, however, they will automatically buy $200 worth of shares — at $8 per share. The investor is able to add 25 shares to his or her account, which now contains 125 shares worth $8 each. That’s a total of $1,000, which was the original account value before the capital gain distribution was paid.
Capital gain distributions (shown in Box 2a of your Form 1099-DIV) are taxed as long-term capital gains. The tax rate for long-term capital gain distributions (assets held for more than 1 year) is determined by an individual’s ordinary income tax bracket:
Short-term capital gain distributions (assets held for 1 year or less) are subject to tax at ordinary income rates.
For state taxation, the treatment of capital gain distributions varies from state to state and may not follow the federal income tax treatment. Consult your tax advisor or your state tax authority for more information about state income tax reporting of these distributions.
Generally, withdrawals from retirement accounts and annuities are taxed at ordinary income tax rates. Thus, the lower rates on long-term capital gains do not apply to withdrawals from these accounts.
Investors are required to include these amounts on their federal and state, if applicable, income tax returns. This is true even if they reinvested their capital gain distributions or if the fund’s share price declined during the year.
Capital gain distributions paid by a fund should not be confused with capital gains you may realize when you sell or exchange mutual fund shares. If you sold or exchanged fund shares, your capital gain or loss depends on your cost basis for those shares.
Qualified dividends are subject to special lower tax rates when paid to an individual taxpayer who meets a holding period requirement.
For a dividend to be a qualified dividend:
Yes. A mutual fund generally can pass on the qualified dividends it receives.
Investors will receive this information on Form 1099-DIV, mailed in late January of every year.
Yes. To be eligible to treat all or a portion of a fund’s dividend as qualified, an investor must have held the fund’s shares for at least 61 days during a 121-day period that begins 60 days before the fund’s ex-dividend date. You cannot count the day on which the shares were purchased or acquired by reinvesting dividends, but you can count the day the shares are sold when determining the holding period.
Example 1: Kate purchased shares of a mutual fund 60 days before its ex-dividend date. For a dividend to be qualified, she cannot sell her shares until the day after its ex-dividend date.
Example 2: Mark purchased shares of a mutual fund two days before its ex-dividend date. For the dividend to be qualified, he will have to hold his shares at least 59 days after the ex-dividend date.
Example 3: Karen purchased mutual fund shares on two separate occasions and subsequently sold all shares after the fund's ex-dividend date. Let's say Karen's first purchase met the holding period requirement, but her second purchase did not. Therefore, only the portion of the fund’s dividend attributable to the first purchase will be considered qualified.
No. A mutual fund may also pay income dividends that are not qualified, consisting of nonqualified corporate dividends (e.g., dividends paid by certain foreign corporations), interest income and net short-term capital gains.
The tax rate for qualified dividends is determined by an individual’s ordinary income tax bracket.
Dividends that are not qualified dividends are taxed at the appropriate marginal tax rate for ordinary income.
Generally, withdrawals from retirement accounts and annuities are taxed at ordinary income tax rates. Thus, the lower rates on qualified dividends do not apply to withdrawals from these accounts. Nevertheless, retirement accounts and annuities remain attractive investment vehicles, because earnings on these accounts can compound tax-free until withdrawn.
A return of capital is created when a fund pays more in dividend distributions to investors than it earned on a tax basis during the fund’s fiscal year. This amount will be reported in box 3 of Form 1099-DIV as a nondividend distribution. This amount is not taxable as income; however, it will reduce the investor’s cost basis. A return of capital that exceeds an investor's cost basis must be reported as capital gains.
A fund may distribute return of capital in order to pay dividends consistent with its respective yields. Only a limited number of fixed income American Funds are likely to pay return of capital distributions.
This material is intended for use by financial professionals or in conjunction with the advice of a financial professional.
Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the fund prospectuses and summary prospectuses, which can be obtained from a financial professional and should be read carefully before investing.