Investors should start by gauging how meaningful the capital gains distributions are to their portfolios.
Distributions are only an issue for investors if they hold mutual funds in a taxable account. (If you keep funds in retirement accounts, such as traditional or Roth IRAs, you need not worry about the distributions because taxes on those gains are deferred until you withdraw money from those accounts.)
Most funds give investors estimates of what their capital gains will be for the year in November. It's not just how the fund performed in one year that causes the distribution. A fund could have held onto its winners from last year and sold them this year, generating a larger capital gain.
"First, determine if the distribution is significant, 5 percent or higher, or insignificant, less than 5 percent," said Sterling Neblett, a certified financial planner and founding partner of Centurion Wealth Management in McLean, Virginia. "If the distribution is significant, we compare the tax consequences of taking the distribution with the tax consequences of selling the fund or sidestepping the distribution."
For example, if you bought a stock fund this year that gained 14 percent and has a long-term capital distribution of 6 percent, you might be better off taking the distribution rather than incurring a 14 percent short-term capital gain, Neblett said. Why? Because short-term capital gains are taxed at a higher rate than long-term ones.