What Is the Difference Between Income Dividend & Capital Gains Distributions?

by Tim Plaehn

A mutual fund can pay investors two types of distributions: dividends and capital gains. Both are part of the total return from a mutual fund investment. The different distribution types are usually paid out on different schedules. More importantly, dividends and capital gains are reported on taxes differently and can be taxed at different rates.

Distribution Requirements

The laws and rules governing the management of mutual funds require a fund to pass through any money earned by the fund's portfolio to investors as the different types of distributions -- dividends or capital gains. Distributions must be made at least once a year to pay out earnings to fund investors. Each individual mutual fund decides on the frequency and timing of the fund's pay outs. Money an investor receives from a mutual fund in the form of a distribution is a taxable event and must be reported on the investor's annual tax return, even if the dividend or capital gains are reinvested.

Dividend Types

Dividend payments from a mutual fund are the results of income earned on the fund's portfolio. The fund may earn dividends from stocks or interest payments from bond investments. When paid by the fund, these earnings are classified as dividends, but maintain the tax characteristics of the original income source. As examples, qualified stock dividends pass through as qualified mutual fund dividends and tax free interest from municipal bonds becomes tax free dividends from a municipal bond mutual fund.

Fund Capital Gains

If a mutual fund sells a security for a profit, a capital gain has been realized by the fund. If the total amount of fund gains exceeds the capital losses for the year, the net amount of gains must be distributed to shareholders. Capital gains from the fund will be separated into a short term gains distribution and a long term gains distributions. These capital gains will be reported on an investor's tax return. Short and long term gains can be combined with like gains from other investments or offset by other capital losses. A mutual fund cannot distribute losses, so excess losses in a year are carried forward to future years.

Timing of Distributions

Funds earning income from their portfolios typically pay dividends on a regular schedule. Most bond funds pay monthly dividends and stock funds pay quarterly. Capital gains distributions are usually paid once a year in the last few days of December. All investors who own shares on the date of a fund's capital gains distributions will receive the payouts and must declare the gains on their income taxes. An investor who buys fund shares just before the distribution must declare the gain even if she has not made any money in her mutual fund account. An investor should avoid making a large investment into a mutual fund in December before the capital gains distributions have been made.