Capital gains distribution
By law, every year, a mutual fund must distribute that year's net investment income (the total of dividends and interest received, less fund expenses) and net realized gain (gains less losses on securities sales) to its shareholders. These distributions are taxable income reported to the IRS on Form 1099. Investors must report the income on their tax returns.
Many investors find the extra income from capital gains distributions bothersome, especially when stock prices shift downward sharply. As mutual fund investors sell their shares, fund managers are forced to sell stocks to meet the demand for cash. When they sell their stocks that have appreciated in value, they realize a capital gain, which had until then existed on the books as only a paper profit). As a result, if investors are holding shares in a declining market, they can receive a sizeable capital gains distribution (and tax bill) in a year with major paper losses.
To avoid taking a capital gains hit, investors are advised to hold off on mutual fund purchases late in the calendar year. Otherwise, they risk making a purchase just before the distribution, which generally (but not always) happens near the end of the calendar year. Investors thus have to pay for gains they didn't participate in.
Index funds have the advantage of fewer capital gains distributions, because they make fewer buy and sell transactions. Tax-managed mutual funds make an effort to minimize capital gains distributions as well.
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