When you invest in a fund, perhaps for your retirement, you'll likely be asked if you want to reinvest your capital gains. This question can carry some consequences at the end of the year, so it's important that every investor understands what, exactly, it means to reinvest your capital gains.

Funds and capital gains made simple
Capital gains are a form of income earned by buying an investment at a low price and selling it at a higher price. If you bought shares of XYZ Corp. for $2 and sold them for $10, you would have a "capital gain" of $8 per share.

Most people buy funds rather than invest in individual stocks. When you invest in a fund, you essentially turn your money over to a firm to make investment decisions for you. The manager has the job of buying and selling investments -- stocks and bonds, for example -- to generate a return that matches the fund's goals. As the fund manager buys and sells investments it will generate capital gains for you.

By law, most funds are required to distribute capital gains to their shareholders in the form of a distribution. These distributions are usually paid at the end of the year. Rather than receive these distributions in the form of cash, fund companies and brokerages often ask if you would prefer to have the capital gains automatically reinvested back into the fund.

Why it matters
When funds generate capital gains by buying and selling investments for their clients, they generate a tax liability for investors.

Suppose you invested $1,000 into a fund. At the end of the year, it pays you a $20 capital gains distribution. If you hold this fund in a taxable account you'll receive a form 1099-DIV from the fund, which will explain how much of this $20 distribution is a short- or long-term gain, how much came from dividends, or how much is ordinary income.

Depending on the classification, these sources of income are taxed differently. If you own the fund in a retirement account like a 401(k) or IRA, taxation is simply irrelevant, and you won't receive the relevant tax forms. If you own the fund in a taxable account, however, you'll pay different tax rates depending on the classification of the income.

But let's not get caught up in the taxes for each type of gain, because it really doesn't have much impact on the question at hand: Should you reinvest your capital gains back into the fund?

There are a few things to keep in mind:

  1. Your behavior. Few people frequently log into their accounts to check their performance or whether they have received a distribution from a fund -- and that's perfectly OK! If this is you, and you hold your funds in a tax-deferred or tax-exempt account (most retirement accounts) it's probably best to have the capital gains automatically reinvested for you. Why let cash build up when it could earn more money invested in the market? Let those gains make you more gains!
  2. Is it taxable? Capital gains generated by funds held in a taxable account will result in taxable capital gains, even if you reinvest your capital gains back into the fund. Thus, it may be smart not to reinvest the capital gains in a taxable account so that you have the cash to pay the taxes due.
  3. Are you retired? If so, you may prefer to take your capital gains distributions as cash to supplement your income. Taking your distribution as cash may reduce how much of your investments you need to sell each year to meet your spending needs, potentially helping you avoid transaction costs, withdrawal fees, and other expenses brokerage firms and fund companies use to nickel-and-dime their clients.

At the end of it all, it's really quite simple: If you hold your funds in an account where taxes are inconsequential, the decision to reinvest your capital gains is mostly a matter of convenience. If you hold your funds in a taxable account, you'll need to make the decision of whether or not you want to pay the taxes out of pocket, or use the distributions to help you cover any capital gains tax bills.

If it's any consolation, keep in mind that annual capital gains distributions are usually pretty small as a percentage of how much you have invested. In 2014, a year with some of the largest distributions in recent history, the average stock fund paid out about 9% of its value in distributions to investors. This isn't a decision you should lose sleep over. 

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