Is your mutual fund or brokerage asking you if you want to reinvest your capital gains? Here's what they really want to know, what they mean, and how to decide what to do.
When you invest in a fund, perhaps for your retirement, you'll probably 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.
We'll explore that question here. For more on the ins and outs of investing, including a helpful list of brokers to pick from, check out our Broker Center.
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:
- 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!
- 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.
- 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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FAQs
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.
What does it mean when you reinvest capital gains? ›
Some investors believe that when they reinvest dividends or capital gains—meaning they use the proceeds to buy more shares of the investment—that distribution becomes part of their investment return.
Does reinvesting capital gains avoid taxes? ›
Do I Pay Capital Gains if I Reinvest the Proceeds From the Sale? While you'll still be obligated to pay capital gains after reinvesting proceeds from a sale, you can defer them. Reinvesting in a similar real estate investment property defers your earnings as well as your tax liabilities.
What happens if you reinvest stock gains? ›
Individuals reinvest the proceeds into specified assets before the end of 6 months from the day the asset was sold. Capital gains should not be more than the investment amount. If only a portion of gains were reinvested, an exemption under capital gain would be applicable only on the amount that was reinvested.
Is it better to reinvest dividends or cash? ›
Your Money Could Lose Value Due To Inflation: Keeping your cash liquid will result in depreciation over time. Keeping the dividends reinvested instead allows your money to grow with the market over time.
What is the 2 out of 5 year rule? ›
When selling a primary residence property, capital gains from the sale can be deducted from the seller's owed taxes if the seller has lived in the property themselves for at least 2 of the previous 5 years leading up to the sale. That is the 2-out-of-5-years rule, in short.
How do I avoid capital gains tax on the sale of my home? ›
As long as you lived in the property as your primary residence for 24 months within the five years before the home's sale, you can qualify for the capital gains tax exemption.
How long do you have to reinvest capital gains before paying taxes? ›
A: You can defer capital gains taxes by using a tax deferred exchange, which means that you reinvest the windfall from the sale into a replacement property. However, you need to act quickly. If you wait more than 180 days to reinvest, you will have to pay taxes on the proceeds.
Do you pay capital gains after age 65? ›
This means right now, the law doesn't allow for any exemptions based on your age. Whether you're 65 or 95, seniors must pay capital gains tax where it's due. This can be on the sale of real estate or other investments that have increased in value over their original purchase price, which is known as the 'tax basis'.
What is a simple trick for avoiding capital gains tax on real estate investments? ›
A few options to legally avoid paying capital gains tax on investment property include buying your property with a retirement account, converting the property from an investment property to a primary residence, utilizing tax harvesting, and using Section 1031 of the IRS code for deferring taxes.
If your goal is long-term portfolio growth, dividend reinvestment makes sense: Reinvested dividends help grow your investment. If you aim to generate an income stream or fund an immediate financial need, you're better off taking cash dividends.
How do I avoid capital gains on my taxes? ›
Here are four of the key strategies.
- Hold onto taxable assets for the long term. ...
- Make investments within tax-deferred retirement plans. ...
- Utilize tax-loss harvesting. ...
- Donate appreciated investments to charity.
You can deduct costs of buying, selling or improving your property from your gain. These include: estate agents' and solicitors' fees. costs of improvement works, for example for an extension - normal maintenance costs like decorating do not count.
What is the downside to reinvesting dividends? ›
Dividend reinvestment has some drawbacks. One downside is that investors have no control over the price at which they buy shares. If the stock gains significant value, they'd still buy shares at what could be a high price.
Are reinvested dividends taxed twice? ›
Dividends are taxable regardless of whether you take them in cash or reinvest them in the mutual fund that pays them out. You incur the tax liability in the year in which the dividends are reinvested.
How do I avoid paying taxes on reinvested dividends? ›
Reinvested dividends may be treated in different ways, however. Qualified dividends get taxed as capital gains, while non-qualified dividends get taxed as ordinary income. You can avoid paying taxes on reinvested dividends in the year you earn them by holding dividend stocks in a tax-deferred retirement plan.
How long do you have to reinvest capital gains on a house? ›
However, you need to act quickly. If you wait more than 180 days to reinvest, you will have to pay taxes on the proceeds.
Do I have to pay capital gains tax immediately? ›
It is generally paid when your taxes are filed for the given tax year, not immediately upon selling an asset. Working with a financial advisor can help optimize your investment portfolio to minimize capital gains tax.
Are gains automatically reinvested? ›
With a DRIP, an investor's cash dividends and capital gains distributions are reinvested into their account automatically, helping them accumulate more shares of the same stock, at no charge.
Why would the owner want to reinvest the money? ›
You needed funds to get your business started. And, of course, there are operating expenses and overhead costs that keep it going. By reinvesting profits, however, you can drive growth and increase revenue.
