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Many investors may be surprised to learn that not only are they likely to receive capital gains distributions this year, but those distributions may be significantly higher than last year.

To clarify, capital gains are any increase in an investment’s value, whether it has been sold or not. Capital gains distributions are the payments a mutual fund or an exchange-traded fund (ETF) sends to investors toward year-end that are their share of a fund’s proceeds. An investor must pay taxes on capital gains distributions in that tax year, whether they are reinvested in the fund or not.

The good news is that according to current IRS regulations, capital gains distributions from mutual funds or ETF holdings are taxed at long-term capital gains rates, regardless of how long the shares of the fund have been owned. The long-term tax rates for capital gains currently stand at 0%, 15% or 20%, depending on taxable income and filing status.

 

There are a few key considerations and decisions that need to be made regarding capital gains distributions: 

 

Should you hold or reinvest your capital gains distributions? 

Typically, capital gains distributions are reinvested into the fund. Doing so keeps those assets working for you and potentially earning an attractive return. Distributions that are left in cash or taken out of the account should be earmarked for a specific use or immediate goal, otherwise it can be opportunity “left on the table.”

 

Should you rebalance your portfolio ahead of capital gains distributions? 

Typically, an investor should not sell out of funds just because they are estimating a capital gain distribution. This is true especially if the original reason for holding the fund is still intact (lower volatility, attractive valuation, etc.) In other words, we don’t want “the tax tail to wag the investment dog.” However, if the prospects for the fund don’t look attractive, and it is estimated to pay a larger than normal capital gain distribution, it may be a good opportunity to sell out of the fund prior to the ex-date and look for a better investment opportunity elsewhere. Consult with your advisor to make that determination. 

 

Should you adjust your estimated or annual tax payments? Those who pay estimated taxes may want to revisit their Q4 payments based on expected capital gains distributions, as the taxes on capital gains may change. For those who don’t pay estimated taxes, it is still wise to review capital gains distributions in January to determine how they might affect your overall tax situation and whether you need to set aside funds to pay taxes owed.

 

Finally, know your tax brackets and how they could be affected by any capital gains distributions. Understand that tax rates for capital gains are calculated differently than ordinary income tax rates. Your capital gains distributions, if significant enough, could increase your overall income, which could bump you into a higher income tax bracket. Work with your advisor and tax accountant to explore whether this might be the case in your situation, and what you can do to mitigate the possibility. 

To further discuss capital gains distributions and what they could mean for your situation, please contact your advisor.