Capital gains refer to profits realized from the sale of an investment. When you realize gains from an investment, you have two options: take your profit and walk, or reinvest your gains. Understanding how reinvesting capital gains works will help you become a savvier investor and realize even greater gains in the long run.
Reinvesting capital gains refers to taking your original investment, plus the gains realized by that investment, and putting both into a new investment. So if you initially invested $5 in a share of a company’s stock, and sold when the share was at $8, you are then turning around and reinvesting that full $8 elsewhere. Because you’re now investing more than you previously were ($8 versus $5), assuming that you invest wisely, the potential for greater capital gains increases.
Individual Stock Sales
There are two common scenarios in which you might realize gains from investments. The first is a straightforward sale of a stock by an individual investor. Using the previous example, let’s say you purchased a share of a stock for $5 and it’s now worth $8. For that one share, your gain is $3. In this scenario, you’d receive a dividend check. To reinvest that money, you’d have to send the money in that check right back out to purchase shares of another company’s stock.
Stock Sale in Mutual Funds
The second scenario is shares of stock sold by a mutual fund in which you have ownership. This is also the most common of the two scenarios. Because the sale and purchase of the individual stocks in the mutual fund are professionally managed, you may never sell a stock -- but stocks in a mutual fund still get sold and new ones are bought. When stocks are sold, you get a capital gains distribution. Unlike with the straight sale of stocks, though, distributions from the sale of stocks in a mutual fund tend to be automatically reinvested, so you’re not receiving a dividend check and then having to resend that same amount of money to purchase different stocks.
Even though you’re not seeing any cash from the sale of your shares when you reinvest, there are still some key tax implications you should be aware of. The dividends will be treated by Uncle Sam as ordinary income. As such, they will be taxed according to the tax bracket you fall under. What this means is that after all is said and done, you may be reinvesting $8 (your initial investment plus gains), as stated in the previous example, but at the end of the tax year you’ll have to pay the Internal Revenue Service (IRS) taxes on your gains, so those gains will ultimately not be as great as they first appear.