Updated February 4, 2008

How capital gain distributions from mutual funds are taxed.

If a mutual fund has long-term capital gains, it can designate part of its dividend as a capital gain distribution. The shareholders report this part of the dividend as if it were their own long-term capital gain. These amounts are called capital gain distributions or capital gain dividends.

This treatment applies only to long-term capital gains. If your mutual fund dividend includes short-term capital gains, you must treat that portion of the dividend as ordinary income, not capital gain.

On rare occasions, mutual funds make capital gain allocations instead of capital gain distributions. If your mutual fund makes a capital gain allocation you’ll receive a special form: Form 2439, Notice to Shareholder of Undistributed Long-Term Capital Gains.

How capital gain distributions are taxed

A capital gain distribution is taxed as long-term capital gain. That’s true even for shareholders who have held the mutual fund shares less than a year. Generally this means that favorable rates apply: you are likely to pay less tax on this type of dividend than on an ordinary dividend.

This capital gain is treated the same as if you personally entered into a transaction that produced capital gain. For example, if you have other capital gains and losses from stock trading in the same year, you would include the mutual fund capital gain distribution in the overall calculation used to determine the net amount taxable at favorable rates.

The tax rate on the capital gain distribution depends on your tax bracket. Long-term capital gain is generally taxed at 15% if your tax bracket is 25% or higher. If the gain falls into the 15% or 10% tax brackets, it’s taxed at 5% through 2007 and 0% beginning in 2008. Higher rates apply to some special categories of long-term capital gain, however.

Note: If you receive a capital gain distribution and subsequently incur a short-term capital loss on a sale of mutual fund shares you held six months or less, see Short-Term Capital Losses for a special rule.

Reporting capital gain distributions

Most people use tax professionals or software programs to prepare their tax returns nowadays, and these people shouldn’t have to about proper reporting for this item. If you’re one of those hardy individuals who still prepare their tax returns by hand, be sure to follow instructions carefully for this item. Some people overlook the steps required to obtain the benefit of the lower tax rate for long-term capital gain. Details depend on your individual filing situation, with some people applying the lower rates on Schedule D and others using a worksheet in the instructions for Form 1040 or 1040A.