In this article, we’ll discuss the different types of distributions and how they affect the shareholders that receive them.

Securities held within mutual funds may generate capital gains or earn dividends throughout the year. Mutual funds are required to distribute any net capital gains and accrued income to its shareholders on, at least, an annual basis.

These distributions can either be reinvested back into the fund or paid out, but the choice does not affect the taxable status of the distribution. Distributions made by mutual funds held within a tax-advantaged account such as an IRA or 401(k) are not taxable.

For more information on the taxation of mutual funds, take a look at our article on How Mutual Funds Are Taxed.

There are four primary types of mutual fund distributions:

1. Capital Gains
2. Dividends
3. Interest
4. Return of Capital

Capital gains distributions are made as a result of the selling of securities within the fund throughout the year. The fund will make a distribution if there are more gains than losses. Capital gains distributions are usually made just once around the end of the year.

Besides mutual funds, exchange traded funds (ETFs) also provide distributions.

Distributions are split into short-term and long-term gains. Short-term gains are those that are generated from securities held for less than one year, while long-term gains come from securities held longer than one year. Long-term capital gains are taxed at the long-term capital gains rate, which can range from 0% to 20% depending on the shareholder’s tax bracket. Short-term capital gains are taxable at the shareholder’s ordinary income tax rate, which can range from 10% to 39.6%.

In this regard, check out the Fidelity Contrafund (FCNTX) that often makes capital gains distributions.

For more information, check out our article on ETF Distributions and Capital Gains.

Dividends are cash distributions that come as a result of owning stock. Dividends paid on securities held within the fund are typically accrued by the fund and distributed to shareholders on either a monthly or quarterly basis. Dividends distributed by the fund are taxable at the shareholder’s ordinary income tax rate.

The T. Rowe Price Equity Income Fund (PRFDX) is a fund that pays a quarterly dividend.

Find out how much you can make investing in dividend paying stocks with Dividend.com’s Dividend Reinvestment Calculator.

Interest typically comes from fixed income securities such as bonds and certificates of deposit (CDs). It is accumulated and distributed in much the same way that equity dividends are and is taxed at the shareholder’s ordinary income tax rate.

From the mutual fund’s standpoint, dividends and interest are essentially treated the same. When a mutual fund makes a dividend distribution, it’s the income accrued from the combination of equity dividends and bond interest.

The Vanguard Total Bond Market Index Fund (VBMFX) is a fund that pays the interest accrued from its fixed income investments every month.

A return of capital distribution comes from when the fund returns a portion of investor’s original investment. It is a non-taxable event and is not considered either a dividend or capital gain distribution.

Return of capital distributions occur most frequently with real estate investment trusts (REITs) and master limited partnerships (MLPs). These investments will occasionally return capital to shareholders when the fund is unable to generate enough income from its investments to make expected payments and needs to use original investor capital to make up the difference.

The Vanguard REIT Index Fund (VGSIX) is an example of a fund that has made return of capital distributions in the past.

Tax considerations are an important part of any investment and understanding how and why mutual funds make distributions will help make you more prepared. Utilizing smart tax strategies, such as avoiding making large investments into mutual funds just prior to the fund making a capital gain distribution, is a good way to keep more money in your pocket.

To learn more about taxation of mutual fund distributions, check out the Taxation section on our website.