Capital gain distributions are paid to investors by mutual funds, typically at years end, when during the year the fund has sold holdings which have gone up in price since they were purchased by the fund. Essentially, the profits from transactions made by the funds are distributed to investors that own the mutual fund.
However, one question everyone faces when they make such a gain is, “Should I reinvest capital gains or take them as cash?” A careful study of pros and cons of re-investing capital gain payments will help you make an informed decision to this typical question.
One of the significant advantages of re-investing your capital gains is that the amount available for investment amount increases and so does the return on it as the reinvested gains forms the engine of a growing portfolio. All that needs to be done is simply instruct your investment manager to automatically re-invest all the capital gain proceeds into your account. Once done, your earnings coupled with initial investment amount work to earn even higher amounts of dividends and capital gains. If you choose to re-invest the capital gain payments, there is no commission (also referred to as ‘load’) amount charged by the investment manager as they generally waive off the sale charges if you include the earnings amount in the investment account.
In terms of tax collected by the Internal Revenue Service (IRS) on both dividend income and capital gains, you can exercise the liberty of delaying tax payments if you re-invest the gain back into your investment account. Though you will have to pay the tax on capital gains ultimately when you withdraw the cash from your account, re-investing the amount can help you better plan your tax obligations and payments. You also need to analyse if your capital gain is termed as a short term or long term depending on the holding period (time from acquisition of stock to its disposal) as the IRS has different tax rates for the two categories with short-term gains taxed at a relatively higher rate.
The biggest disadvantage reinvesting capital gains is that you do not get anything to spend as the gain is simply used to purchase more shares of the fund, compounding your investment amount to benefit you sometime in the future. It doesn’t reaches your bank account and can not be spent on anything else (until you ultimately sell the shares of the mutual fund). This can be particularly problematic for people who have current obligations to meet and are living off their investments.
Another downside of re-investing the capital gain is the risk you take by re-investing that amount. Nothing is certain and experiencing the same percentage gain in future is no exception. So the decision to cash the gain or compound it for even better gain in the future will depend on the particular fund’s future outlook and market circumstances.
The eventual decision you take when thinking should I reinvest capital gains will depend on the individual. If the investment has been made for long-term purpose, then it is probably best to re-invest it. However, if you are looking for immediate gains, you should take the exit and enjoy the proceeds in your pocket. Still confused? Ask your investment manager for his/her take on what’s best for you.