When you invest in a fund, you’ll probably be asked if you want to reinvest your capital gains. Every investor must understand what it means to reinvest their capital gains. Capital gains are income earned from buying an investment at a low price and selling that same investment at a higher price. For example, if you bought shares of ABC Corp. for $1 and sold them for $5, you would have a “capital gain” of $4 per share.
Many people buy funds instead of investing in individual stocks. When you invest in a fund, you turn your money over to a company to make investment decisions for you. The manager’s job is buying and selling investments — stocks and bonds, for example — to give a return that matches the fund’s goals. As the manager buys and sells investments, your fund will generate capital gains.
The law states that most funds are required to distribute capital gains to their shareholders which are usually paid at the end of the year. Rather than automatically distributing these capital gains in cash, companies and brokerages usually ask if you would like to have the capital gains (automatically) reinvested into the fund. So what is the difference and why does it matter?
When funds accumulate capital gains, they also create a tax liability for investors. If you invested $750 into a fund, it could pay you a $25 capital gain at the end of the year. If this fund is in a taxable account, you will receive a 1099-DIV explaining how much of this $25 is a short- or long-term gain, what part of it came from dividends, and what is ordinary income.
Depending on how it’s classified, this income can be taxed differently. If your fund is a retirement account like a 401(k) or IRA, taxation is simply not an issue and you will not receive the relevant tax forms. If the fund is in a taxable account, you will pay different tax rates depending on how the income is classified. The question is, should you reinvest your capital gains back into the fund? There are a few things to think about:
- Your conduct. Not many people log into their accounts a lot to check their performance or if they have received a distribution from a fund — and that’s fine. If that’s your behavior, and you hold your funds in a tax-deferred/tax-exempt account (which is most retirement accounts) it might be best to have the capital gains automatically reinvested for you.
- Are they taxable? Capital gains made by funds in a taxable account will result in taxable capital gains, even if you insert your capital gains back into the fund. In this case, it might be smart not to reinvest your capital gains in a taxable account. This way you’ll have the cash to pay the taxes due if you have large capital gains.
- Are you retired? If you are, you might prefer to get your capital gains as cash to supplement your income. Taking your distribution as cash might reduce how much of your investments you need to sell annually to meet your spending needs, maybe helping you reduce transaction costs, withdrawal fees, and other expenses.
If you hold your funds in an account where taxes don’t matter, the decision to reinvest your capital gains is most advantageous. If they are in a taxable account, you will need to know whether or not you want to pay the taxes out of your pocket or use the distributions to pay capital gains tax bills. For more info or questions regarding your finances, contact your account manager or CPA.
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