Mutual funds help millions of people invest modest amounts while getting the diversification they need. But funds come with some quirks that are less than ideal, and one of the worst involves the capital gains distributions they make. These distributions can lead to an increased tax bill, and they force you to look closely at your cost basis to determine whether adjustments are necessary.
Understanding capital gains distributions
Mutual funds don't pay taxes. Instead, they pass through any tax liability they incur to their shareholders. When funds sell their investments at a profit, the capital gains get distributed out to investors, and unless you invest in a tax-deferred account like an IRA, those distributions are taxable at capital gains rates.
Mutual fund investors have two choices on what to do when a fund pays a capital gains distribution. They can take the cash, using some of it to pay the tax and keeping the rest. Or they can reinvest the distribution back into the mutual fund, buying more shares at the prevailing price and taking no cash. Which decision you make determines how your cost basis gets adjusted.
Basis adjustment for reinvested capital gains distributions
If you reinvest a capital gains distribution, then it will be treated the same way any other investment in the fund would. Take the amount of the distribution and add it to the previous cost basis for your fund shares. The total is the new cost basis for your entire fund holdings.
This makes sense, because if your cost basis didn't go up, then you'd end up getting taxed twice: once when the distribution is made, and once when you sell the shares. Even though you've reinvested the distribution, you still have to pay tax at the time it's made. But because your basis adjusts upward, you'll get credit for having had to treat it as taxable income previously.
No basis adjustment for capital gains distributions received in cash
By contrast, if you take a capital gains distribution in cash, no basis adjustment is necessary. You simply pay tax on the amount received, and the basis in your remaining fund shares stays the same.
The complexities of tracking cost basis makes fund investors face a dilemma. If they reinvest distributions, they have to deal with cost-basis adjustments. But if they take cash, they don't get the compounding benefit that reinvestment offers. Tracking cost-basis adjustments isn't difficult, but it can get burdensome.
Regardless of whether you take cash or reinvest a capital gains distribution, it's important to track cost-basis information accurately. Otherwise, your tax bill could end up being bigger than it needs to be.
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