Ask the Adviser: What is the Difference Between Capital Gains and Capital Gains Distributions? 

Surprise: Your “tax bracket” might not mean what you think it means.  In the U.S. tax system, two primary tax rates apply to investors: Ordinary Income Tax and Capital Gains Tax. The appli­cation of each depends on the source of your income and profit. 

Ordinary Income vs Capital Gains 

Ordinary Income Tax is applied to wages, Social Security benefits, IRA distri­b­u­tions, taxable interest (from bonds, CDs, or bank accounts), and non-qualified dividends.  
Capital Gains Tax, on the other hand, applies to assets purchased, held for more than one year, and sold for a profit – such as real estate, a business, collectibles, or invest­ments like stocks. The advantage of long-term Capital Gains Tax is that the rates are typically lower than your ordinary income tax rates. 

*Note: Assets sold after being held for at least 366 days qualify as Long-Term Capital Gains. Conversely, assets sold before this period are treated as Short-Term Capital Gains and taxed as ordinary income.  

Understanding Capital Gains Distribution 

So far, so good, but there’s another taxable event investors often overlook: Capital Gains Distributions. 

If you hold mutual funds in a taxable investment account, like an individual or joint brokerage account, you may notice a line on your tax return labeled “Capital Gains Distri­b­u­tions.” These distri­b­u­tions are included with your regular capital gains and are taxed accord­ingly, even if you didn’t sell any invest­ments yourself. 

How Capital Gains Distributions Happen 

Many mutual funds are actively managed, meaning a team of fund managers are buying and selling individual securities throughout the year. When those managers sell invest­ments at a profit, the fund must pass those gains to share­holders through a Capital Gains Distri­b­ution. Since most mutual fund companies issue these distri­b­u­tions toward the end of the year, many investors are caught off guard by an unexpected tax bill, right when they thought their annual tax plan was complete. 

Think of it this way:  

• Capital Gains occur when you sell an investment for a profit. 

• Capital Gains Distri­b­u­tions occur when someone else sells invest­ments on your behalf. You pay tax on your share of those profits. 

The Hidden Impact on Your Taxes 

This is a common pitfall we often see when reviewing portfolios that we don’t manage. Many investors unknow­ingly pay taxes on capital gains distri­b­u­tions, unaware that more tax-efficient investment options are available. It can be an unpleasant surprise when you spend months mapping out a careful tax plan, only to have it disrupted in November when mutual funds issue their year-end distri­b­u­tions. These unexpected gains can have ripple effects beyond your immediate tax bill. 

For example, they can: 

• Increase your Medicare premiums in future years. 

• Make a larger portion of your Social Security benefits taxable. 

• Change the amount of your estimated federal or state tax payments. 

Even a well-diversified portfolio can be ineffi­cient from a tax stand­point. Recog­nizing and addressing these hidden costs can make a meaningful difference in your long-term financial outcomes. 

What can be done about this situation?   

One practical way to reduce surprise tax bills is to consider Exchange-Traded Funds (ETFs) instead of mutual funds in your taxable investment accounts. 

Unlike many actively managed mutual funds, most ETFs do not regularly buy and sell individual companies inside the fund. This means they typically generate little to no capital gains distri­b­u­tions during the year. ETFs can still provide the same level of diver­si­fi­cation as mutual funds, but often in a more tax-efficient way. 

However, transi­tioning from mutual funds to ETFs must be done carefully. If you sell all your mutual funds at once, the sale itself can trigger additional taxable capital gains—an outcome you’re likely trying to avoid. Working with a profes­sional adviser can help you develop a strategy that minimizes taxes during the transition. 

Note: Mutual funds can be a great option for retirement accounts, such as IRAs. Even when capital gains distri­b­u­tions occur, they are not taxed until the funds are withdrawn. This is why income-producing invest­ments, such as bonds, are generally better suited for tax-deferred accounts than for taxable accounts. 

If you’re exploring a more adaptive and efficient approach to managing your portfolio, learn about our Agile Investment Strategy. 

Working with a Professional 

Tax efficiency is about more than just lowering your annual tax bill—it’s about maximizing what you keep over time. Working with a fiduciary financial adviser can help you evaluate your current invest­ments, identify ineffi­ciencies, and create a plan that minimizes unnec­essary taxes while supporting your long-term goals. 

If you’d like personal guidance, contact Rodgers & Associates to start a conver­sation with one of our experi­enced advisers. 

For additional IRS resources, visit IRS Topic No. 409: Capital Gains and Losses.