Tax on mutual funds capital gains

Capital gains — profits from an increase in the value of the securities held by the mutual fund — may be either realized or unrealized. Their tax status differs accordingly, with only realized profits being eligible for taxation. Here’s how it works.
Capital gains are realized when the fund manager sells stocks (or, less commonly, bonds) at a price greater than their purchase price. When stocks held by the fund increase in price but are still held, the capital gains are unrealized.
Capital gains are taxed only when they are realized. For example, suppose Sharon owns shares of Fund M, whose net asset value increases by 10% during the course of a year due to a 10% increase of the value of the stocks owned by the fund. If the fund manager sold no securities during the year, the investor would receive no realized gains in the current year — therefore, no taxes due on capital gains. However, suppose Sharon decides to sell her shares of Fund M. (Maybe she needs to cash in her investment in order to make a down payment on a new house.) When she does so, she is realizing (literally “making real”) the profits earned by the fund due to the increase in the value of the stocks it owns. These profits are now capital gains on which Sharon is obligated to pay taxes.
If you plan to sell your mutual fund shares, consider the tax implications of your timing. If the value of your shares has grown significantly, so that you can expect a large tax payment, consider whether you want to accelerate the transaction (making the sale by December of the current year) or to delay it (pushing it back into next January), depending on which year your income may be greater. Realizing your profits and paying taxes on them may be less painful during a year when your income is smaller and your tax rate is therefore lower.
Current tax law also distinguishes between short-term and long-term capital gains. Short-term capital gains are profits from sales of securities held by the fund for 18 months or less. The government taxes these gains at the same rate as ordinary income, just like dividends. In fact, you will actually find short-term capital gains listed in the “dividend income” box on your Form 1099-DIV because the tax rate is the same.
Long-term capital gains, on the other hand, are profits from the sale of securities held by the fund for longer than 18 months. These profits are taxed at a more favorable rate. If you are in the 15% tax bracket, the government taxes any long-term capital gains you enjoy taxed at just 10%; if you are in the 28% bracket or higher, your long-term capital gains are taxed at 20%.
As you can see by its design, federal tax law encourages investors — including fund managers — to hold on to securities for a longer time. Taxing long-term capital gains less heavily than short-term capital gains is another reason why a mutual fund with a lower turnover rate may be more beneficial for the investor than a fund that buys and sells stocks rapidly.