Return of capital happens when you get part of your investment back. It can occur with practically any type of investment, but it is often used as a way for mutual funds to return money to shareholders. Unlike other distributions, return of capital is usually not taxable, since you are just getting back part of your original investment. However, it could create some tax implications in the future.
It’s no surprise that the goal of investing is to make money, whether it be from a regular distribution from your investments or from capital gains when you sell them. Ongoing distributions can be a favorite source of gains for investors since it is recurring income that can help them to manage their cash flow.
Despite what it may feel like, receiving a return of capital from a mutual fund you’re invested in doesn’t actually mean you’re receiving taxable income. Instead, it might simply be a return of the money you’ve already invested in the fund. In this article, we’ll explain what return of capital means in a mutual fund, and how it affects your tax liability.
What is return of capital?
Return of capital (ROC) is a distribution from stocks, mutual funds, or other closed-end funds that represents a return of your original investment. These fund distributions are treated differently from dividend distributions since the fund is simply returning the money you initially invested.
ROC decreases your adjusted cost basis in an investment, and any distributions once your basis reaches zero are treated as a capital gain.
How does return of capital work?
Return of capital occurs most often when someone invests in a mutual fund. In general, there are two common ways that investors make money from their mutual fund investments. First, while they own it, they make money from capital gains when the investment increases in value. Second, they make money when the company or fund pays dividends, meaning some of the profit is being passed along to the shareholders.
In the case of ROC, the fund’s distribution isn’t considered either a capital gain or a dividend. These distributions have a more favorable tax treatment from other investment returns but could increase your tax burden in the future when you sell an investment.
Return of capital occurs when a fund decides to make distributions to investors that are greater than the investment income and realized gains. However, ROC can also refer to the money you receive from selling a stock within a retirement account.
Tax implications of return of capital
It can be exciting to get a distribution you weren’t expecting from a mutual fund. However, it’s important to understand the tax implications of return of capital.
First, understand that as far as distributions go, ROC is the most advantageous scenario for tax purposes. None of the returned funds are subject to either income or capital gains taxes. When you compare that to income from interest, dividends, or capital gains — which are either taxed at your ordinary income tax rate or at the lower long-term capital gains rate — it’s easy to see how many consider ROC advantageous. When it comes to return of capital, you keep 100% of the distribution for yourself.
The immediate tax implications of ROC are clear, but we must also talk about the long-term implications since they aren’t as positive.
Long-term tax implications
In general, you pay capital gains taxes on an investment when you sell it for more than you bought it for. The amount you’re taxed on is the difference between the sales price and your cost basis (usually your purchase price).
However, return of capital decreases your cost basis. For example, if you own $100 worth of mutual fund shares and receive $10 per share as ROC, your new adjusted cost basis is $90. If you sell the shares for $150, you’ll pay taxes on $60 of gains instead of the $50 you would have originally paid taxes on. The amount of tax you’ll ultimately pay depends on whether you held the investment for less or more than one year.
Keep in mind that return of capital doesn’t actually increase or decrease your tax liability. Instead, it simply allows you to receive some of your capital early while deferring the taxes until a later date.
It’s also important to understand what happens to ROC distributions once your adjusted cost basis in a mutual fund becomes $0. Once you’ve received your entire initial investment as return of capital, any additional distributions you receive are considered realized capital gains and taxed as such.
Return of capital example
Return of capital can be a confusing concept, so let’s discuss an example to help you envision how it might work in real life.
Suppose you buy 100 shares in a mutual fund for a purchase price of $50 per share. Your cost basis at the time of purchase is $5,000 (100 shares x $50 per share). At the end of the year, the mutual fund makes a ROC distribution of $5 per share, or a total of $500. Your new adjusted cost basis in the fund is $45 per share or a total of $4,500.
The good news is that you won’t pay income or capital gains taxes on the $500 distribution you received. Instead, it simply reduces your cost basis in each share from $50 to $45. That’s the figure that will be used to calculate your capital gains when you sell the share.
If in the following year the mutual fund makes another return of capital distribution for $5 per share, your new basis in the fund is $40 per share, or a total of $4,000. Each year when the mutual fund makes its return of capital distribution, your adjusted cost basis will be reduced.
Suppose you hold the mutual fund investment for many years and each year, the mutual fund makes a $5 per share return of capital distribution. After 10 years invested in the fund, your adjusted cost basis will reach $0. At that point, you’ll pay capital gains taxes on any return of capital distributions you receive. When you eventually sell your shares, 100% of the sale price will be a capital gain, since your adjusted cost basis is $0.
Benefits of return of capital
It may be difficult to understand whether return of capital is actually a good thing. On the one hand, it means you get money back from your investment. On the other hand, it may result in you paying more taxes in the future.
- Cash flow. One reason individual investors enjoy mutual funds that provide ROC is that it provides a form of cash flow. Unlike other types of recurring cash flow, these distributions aren’t subject to income or capital gains taxes.
- Tax-deferred. As we mentioned, return of capital doesn’t actually increase your tax burden. Instead, it allows you to defer it. The portion of distributions that is considered ROC isn’t taxed, meaning you’re receiving tax-free income today. And you won’t have to pay taxes on those funds until you’ve received a capital gain.
- Possibility of a more favorable tax rate. Holding an investment for more than one year gets you a more favorable tax rate. Instead of being subject to income tax rates, you’ll pay the lower long-term capital gains tax rate. Therefore, even if you receive a return of capital within one year of investing in the fund, you still get to defer the taxes and enjoy the lower tax rate later on.
- Can still grow your investment. Even though you’re receiving a part of your original investment back from the mutual fund, there’s still an opportunity for your investment to grow. That is, as long as the fund doesn’t pass along 100% of its earnings to the shareholders.
Drawbacks to return of capital
It’s also important to note that despite the benefits for an investor of ROC, there could be some downsides. A return of capital can reduce a fund’s net asset value (NAV), especially if that return exceeds the fund’s earnings. This decrease in NAV could be considered a bad sign for the mutual fund.
Return of capital vs. dividends
It’s easy to confuse return of capital with dividends. After all, both options are distributions where certain funds are being passed along to the shareholders.
As we mentioned, return of capital occurs when a mutual fund returns a portion of your original investment, and it reduces your adjusted cost basis in the fund.
However, in the case of dividends, a company is passing along a share of its profit. Unlike with return of capital, you’ll have to pay taxes on any dividends you receive. Those distributions won’t reduce your cost basis in the investment.
Is return of capital a good thing?
Return of capital has some benefits since it’s a form of tax-free income today with the taxes deferred until you receive a capital gain, which can be good. However, some investors may prefer to maintain their higher cost basis, which would make ROC a negative thing.
How does return on capital work?
Return on capital is a bit different from return of capital. Whereas return of capital is a return of an investor’s initial investment, return on capital is a measure of how well a company turns its capital into profits. If you receive an annual return each year from distributions, this is your return on investment.
Is return of capital the same thing as a dividend?
Return of capital and dividends are two different things. Return of capital is a way to receive a part of your original investment back. Dividends allow a company to pass on a share of its profit to the shareholders.
Why do mutual funds return capital to investors?
A mutual fund might decide to return some capital to its investors as a way of helping them to defer taxes to the future. These regular tax-deferred distributions can also be a way of attracting investors to the fund.
However, this isn’t always the case. Some closed-end funds may have unrealized capital gains in their portfolio. Rather than selling simply to meet a distribution commitment, the fund manager distributes ROC to the investors while still investing in the fund’s total return rather than only the distribution rate.
How is return of capital treated for tax purposes?
Return of capital isn’t taxed at the time you receive it. Instead, it reduces your cost basis in an investment, which can increase your realized capital gains — and, therefore, your taxes — in the future.
- Return of capital is a distribution from a closed-end fund or mutual fund that represents all or a portion of your initial investment.
- Because this is a return of your investment, whatever money you receive is tax-deferred. You also don’t have to pay capital gains taxes on this money unless you make a profit.
- As long as a part of your initial investment remains in the fund, this investment can continue to grow.
- ROC isn’t always a positive, as it can reduce a fund’s net asset value.
View Article Sources
- Starting Point: Mutual Funds and ETFs — Texas State Securities Board
- Topic No. 404 Dividends — IRS
- How To Invest In The Stock Market: 8 Basic Concepts — SuperMoney
- Beginner’s Guide to Investing — SuperMoney
- How Capital Gains and Losses Affect Your Taxes — SuperMoney
- How to Use Leverage to Build Wealth — SuperMoney
- What Is Tax Planning? A Guide For Beginners — SuperMoney
- Best Brokerages | May 2022 — SuperMoney
Erin Gobler is a Wisconsin-based personal finance writer with experience writing about mortgages, investing, taxes, personal loans, and insurance. Her work has been published in major outlets, such as SuperMoney, Fox Business, and Time.com.