What Are the Capital Gain Distribution Tax Rates?

An investment in a mutual fund or exchange-traded fund (ETF) can generate income through distributions. These payments represent the fund’s net gains from its trading activities, which are passed on to shareholders. Understanding the tax implications of these capital gain distributions is part of managing investment returns.

Understanding Capital Gain Distributions

Mutual funds and ETFs are pass-through entities for tax purposes. When a fund manager sells securities within the portfolio for a profit, the fund must distribute these net capital gains to its shareholders. These distributions usually occur annually, and the tax liability is passed from the fund to the individual investors.

These distributions are taxable events, even if you have not sold any of your shares in the fund. The payout triggers a tax obligation for that year, whether you receive it as cash or reinvest it to buy more shares. This surprises some investors who assume taxes are only due when they sell their investment.

A capital gain distribution is different from other investment events. It is not the same as the capital gain you realize from selling your own shares of the fund, which is a separate transaction. It also differs from a dividend, which is a payment from a company’s earnings rather than from the sale of assets within the fund.

Determining the Applicable Tax Rate

The tax rate for a capital gain distribution depends on how long the fund held the underlying assets before selling them. The fund passes this classification—either long-term or short-term—on to the shareholder. Most distributions are long-term, which are taxed at lower rates.

Long-term capital gain distributions are taxed at 0%, 15%, or 20%, depending on your taxable income and filing status for the 2024 tax year. For single filers, the 0% rate applies to incomes up to $47,025, the 15% rate to incomes from $47,026 to $518,900, and the 20% rate to incomes above that. For those married filing jointly, the 0% bracket is for incomes up to $94,050, the 15% bracket for incomes from $94,051 to $583,750, and the 20% rate for incomes above that.

A fund can also make short-term capital gain distributions from assets it held for one year or less. These distributions do not receive preferential rates and are taxed as ordinary income, the same as your wages.

A distribution may include gains from specific assets with their own tax rates. Gains from collectibles are taxed at a maximum of 28%, while unrecaptured Section 1250 gain from real estate is taxed at a maximum of 25%. Higher-income investors may also be subject to the 3.8% Net Investment Income Tax (NIIT) on their investment income, including these distributions.

Reporting Distributions on Your Tax Return

Early in the year, your brokerage or fund company will send you Form 1099-DIV, “Dividends and Distributions.” This form details all distributions you received from a fund during the prior tax year. You use the information on this form to complete your tax return but do not file the form itself.

Box 2a of Form 1099-DIV shows your “Total capital gain distribution.” This amount is treated as a long-term capital gain, regardless of how long you have owned the fund shares. Other boxes provide details for gains taxed at special rates, such as those from real estate or collectibles.

You report the total capital gain distribution from Box 2a on Schedule D, “Capital Gains and Losses.” This schedule is used to calculate your overall capital gains and losses for the year. The tax is then computed using the long-term rates.

The final tax from Schedule D is carried over to your main tax form, Form 1040. In some circumstances, you may be able to report the distribution directly on Form 1040 without filing Schedule D if you have no other capital asset sales.

Tax Implications of Reinvested Distributions

Many investors automatically reinvest distributions to purchase additional shares of the fund. This reinvestment does not avoid or defer the tax liability. The IRS considers you to have constructively received the money and then chosen to use it for a new purchase.

When you reinvest, you must add the amount of the distribution to your cost basis in the fund. Cost basis is the total amount you have paid for your shares. Increasing your basis by the amount of the reinvested distribution ensures you are not taxed on that same money again when you eventually sell your shares.

For example, if you receive and reinvest a $200 capital gain distribution, you will pay tax on that $200 in the current year. You must also add that $200 to your cost basis. When you later sell your shares, this higher basis reduces your calculated capital gain, lowering your future tax bill and preventing double taxation.