Mutual Funds are essentially a basket of stocks or bonds managed by an Investment Company. Throughout the course of the year, the Investment Company will continuously monitor the basket of securities based on the investment objective of the portfolio. At times, the Investment Company may sell positions within the portfolio for numerous reasons.
Each sale can create a taxable event, whether at a loss or a gain. If at a gain, the Investment Companies are required to send most of the taxable gain to you as the individual shareholder in what is known as a “Capital Gain Distribution.” You as the shareholder are responsible to pay the taxes on the Capital Gain Distribution.
While there are many behind the scenes accounting processes that are done, Capital Gain Distributions generally don’t affect the overall performance of the fund you’re investing in. The Net Asset Value of the fund will be adjusted to reflect the taxable gain that has been distributed. However, having to pay taxes come tax time could affect your after-tax rate of return. Most Capital Gain Distributions occur near the end of the year, so a thorough review of your holdings and estimated gains is recommend.
Some strategies to mitigate the tax risk include harvesting losses to offset the potential gains, investing in more tax efficient funds, or keeping actively managed mutual funds in retirement accounts so the capital gains continue to grow tax-deferred. Making money and paying taxes is generally a good thing but being mindful of where and how your assets are held could make a big difference.