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As a mutual fund owner, there are a few ways to get returns. One is by selling shares of the mutual fund at a gain. The other is to have internal gains the manager has realized and passed through to the investor, along with other dividends and interest. We call the latter a capital gain distribution.

The short of it…

Capital gains distributions must be made by a mutual fund manager because tax law dictates that substantial portions of investment income and capital gains must be paid to investors. Shareholders will pay long or short-term capital gains tax based on how long they’ve owned the fund. However, this doesn’t mean that investors are losing money. Investors can either take capital gain distributions in cash or reinvest them. 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.

Here are a few tips for dealing with capital gains distributions:

If you already own the fund, do nothing! Enjoy your payout but know you will owe tax on the gain.
If you are going to buy the fund… wait! Otherwise, you’ll need to pay taxes on gains that you didn’t get to enjoy throughout the year.
If you are already planning to sell that fund, go ahead and sell ahead of the distribution. Don’t sell it just to dodge a distribution. There will likely be other tax consequences!

And the long of it…

Another thing to consider is if your mutual fund is “tax-friendly” or if an Exchange Traded Fund (ETF) is better.

A mutual fund manager may rebalance the fund by selling securities to accommodate shareholder redemptions or to reallocate assets. The sale of securities within the mutual fund portfolio creates capital gains for the shareholders, even for those who may have an unrealized loss on the overall mutual fund investment.

In an ETF, the manager accommodates investment inflows and outflows by creating or redeeming “creation units,” which are baskets of assets that approximate the entirety of the ETF investment exposure. As a result, the investor may not be exposed to as much capital gains. Not all ETF index funds are immune though! For example, they may be forced to sell to hit rebalancing targets. So-called strategic-beta funds also construct their portfolios based on a set of rules that can result in more frequent changes and lower tax efficiency than broad-market index products.