Capital gains tax on funds hits you in two ways: when a mutual fund or ETF distributes profits from its own internal trading, and when you sell your fund shares for more than you paid. Long-term gains (on shares or underlying assets held more than a year) are taxed at 0%, 15%, or 20% depending on your income. Short-term gains are taxed at ordinary income rates up to 37%. High earners may owe an additional 3.8% net investment income tax on top. These rules apply to funds held in taxable brokerage accounts.
The Two Ways a Fund Triggers Tax
You can owe capital gains tax on a fund even if you never sell a share. Fund managers buy and sell securities inside the portfolio all year, and when those trades produce a net profit, the fund passes it through to shareholders as a capital gain distribution. Federal law requires regulated investment companies to distribute at least 90% of their investment company taxable income each year to keep favorable tax treatment.1Office of the Law Revision Counsel. 26 U.S. Code 852 – Taxation of Regulated Investment Companies and Their Shareholders Distributions happen whether you asked for them or not.
Your brokerage reports the total in Box 2a of Form 1099-DIV.2Internal Revenue Service. Instructions for Form 1099-DIV If you have distributions set to reinvest automatically, the IRS still treats the full amount as taxable income in the year it was paid.3Internal Revenue Service. Stocks (Options, Splits, Traders) 2 Reinvestment doesn’t defer the tax. It just means you bought more shares with money already counted as income.
A fund can also distribute taxable gains during a year when its share price fell. If the manager sold long-held winners while other positions declined, the remaining shareholders get a tax bill on profits they never took home. This tends to surprise investors most in late fall, when funds make their largest year-end distributions.
The second way tax hits is when you sell. If you redeem or sell fund shares for more than your cost basis, the profit is a taxable capital gain.4Office of the Law Revision Counsel. 26 U.S. Code 1001 – Determination of Amount of and Recognition of Gain or Loss Your basis starts as the original purchase price plus any commissions, and it adjusts upward each time you reinvest a distribution, because you already paid tax on that money. The brokerage sends Form 1099-B after the sale,5Internal Revenue Service. Instructions for Form 1099-B – Proceeds From Broker and Barter Exchange Transactions and you report the transaction on Schedule D of Form 1040.6Internal Revenue Service. 2025 Instructions for Schedule D (Form 1040)
Sell for less than your basis and you have a capital loss. Losses first offset gains of the same type, then the other type. If losses still exceed gains, you can deduct up to $3,000 per year against ordinary income ($1,500 if married filing separately).7Office of the Law Revision Counsel. 26 U.S. Code 1211 – Limitation on Capital Losses Any remaining loss carries forward to future years indefinitely.
How the Rate Is Determined
Holding period sets the rate. Shares held for one year or less produce short-term gains; more than a year produces long-term gains.8Office of the Law Revision Counsel. 26 U.S. Code 1222 – Other Terms Relating to Capital Gains and Losses The clock starts the day after you buy and runs through the day you sell.
Short-term gains are taxed at your ordinary income rate, which for 2026 ranges from 10% to 37%.9Internal Revenue Service. Federal Income Tax Rates and Brackets Long-term gains use a separate schedule with three tiers: 0%, 15%, and 20%.10Office of the Law Revision Counsel. 26 U.S. Code 1 – Tax Imposed
For 2026, single filers pay 0% on long-term gains if taxable income stays below $49,450, 15% up to $545,500, and 20% above that. Married couples filing jointly get roughly double: 0% up to $98,900, 15% up to $613,700, and 20% beyond. The gap between short-term and long-term treatment is real money. A single filer earning $100,000 who sells shares at a $10,000 profit would owe 22% on a short-term gain but only 15% on a long-term one.
Each lot of shares has its own holding period. If you’ve been buying monthly or reinvesting dividends, a single redemption might include lots older than a year alongside lots only a few months old. The 1099-B breaks them out.
Capital gain distributions from a fund always count as long-term for you, no matter how long you’ve held the fund shares. The fund held the underlying assets more than a year, and that character passes through.6Internal Revenue Service. 2025 Instructions for Schedule D (Form 1040)
The Extra 3.8% for Higher Incomes
Higher-income investors face a net investment income tax of 3.8% on top of the regular capital gains rate. It applies to the lesser of your net investment income or the amount your modified adjusted gross income exceeds $200,000 (single), $250,000 (married filing jointly), or $125,000 (married filing separately).11Office of the Law Revision Counsel. 26 U.S. Code 1411 – Imposition of Tax The thresholds are not indexed for inflation.
Net investment income includes capital gain distributions, gains from selling fund shares, dividends, and interest. Someone in the 20% long-term bracket ends up at 23.8% once the surtax applies. Investors in the 15% bracket can still owe the extra 3.8% if their total income clears the threshold.
Choosing Which Shares You’re Selling
If you bought fund shares at different times and prices, the method used to identify which shares were sold changes your tax bill. The IRS allows three approaches for mutual fund shares.12Internal Revenue Service. Publication 550 (2025), Investment Income and Expenses
Average cost divides your total cost by total shares owned. It’s the simplest method and the default at most mutual fund companies. Once you use it for a fund, you generally cannot switch methods for the shares you already held.
First-in, first-out (FIFO) treats the oldest shares as sold first. In a rising market, the oldest shares usually have the lowest basis and produce the largest taxable gain. FIFO is the default for stocks and ETFs.
Specific identification lets you tell your broker exactly which lots to sell. It requires written confirmation, but it gives the most control: you can pick high-basis lots to minimize a gain, or low-basis lots when you want to harvest a loss. For investors who have accumulated shares over years, choosing the right lots can save hundreds or thousands of dollars in tax.
Harvesting Losses and the Wash Sale Rule
If you sell fund shares at a loss and buy the same fund (or a “substantially identical” one) within 30 days before or after the sale, the IRS disallows the loss deduction.13Office of the Law Revision Counsel. 26 U.S. Code 1091 – Loss From Wash Sales of Stock or Securities The loss isn’t destroyed. It gets added to the basis of the replacement shares and reduces the gain when you eventually sell those. The holding period of the original shares also carries over.
The rule applies across all your accounts, including IRAs, your spouse’s accounts, and accounts at different brokerages. It also catches automatic dividend reinvestment that buys new shares inside the 30-day window. Investors harvesting losses often move into a fund tracking a different index during the waiting period.
Why ETFs Usually Generate Smaller Tax Bills Than Mutual Funds
Mutual funds and ETFs both pool investor money, but their internal mechanics produce very different tax outcomes. When mutual fund investors redeem, the manager often sells underlying securities to raise cash. Those sales generate capital gains that get distributed to every remaining shareholder, including people who did nothing.
ETFs handle redemptions in kind, swapping blocks of underlying stocks with large institutional participants instead of selling for cash. Federal law specifically exempts regulated investment companies from recognizing gain on these in-kind distributions.14Office of the Law Revision Counsel. 26 U.S. Code 852 – Taxation of Regulated Investment Companies and Their Shareholders The result: most broad-market ETFs go years without distributing capital gains, while comparable mutual funds distribute them annually. Narrowly focused ETFs or ones tracking less liquid markets can still throw off gains through rebalancing, but the structural advantage is real.
Funds Held in Retirement Accounts Work Differently
Everything above applies to taxable brokerage accounts. Inside a 401(k), traditional IRA, or Roth IRA, the rules change.
In a traditional 401(k) or traditional IRA, distributions and internal fund trading generate no immediate tax. You report none of it on your annual return. You pay ordinary income tax on the full amount when you withdraw in retirement, regardless of whether the underlying gains were short-term or long-term. The preferential long-term rates do not apply to these withdrawals.
Roth IRAs and Roth 401(k)s flip the arithmetic. You contribute after-tax dollars, but qualified withdrawals in retirement are tax-free. No capital gains tax, no ordinary income tax, no net investment income tax on the growth.
Inherited Fund Shares
Fund shares received through an inheritance get special treatment. The cost basis resets to the fair market value on the date the original owner died, wiping out any unrealized gains that built up during their lifetime.15Office of the Law Revision Counsel. 26 U.S. Code 1014 – Basis of Property Acquired From a Decedent If shares bought for $10,000 decades ago were worth $80,000 at death, your basis is $80,000, and you only owe tax on gain above that.
Inherited shares are also automatically treated as long-term, even if you sell them the day after you receive them.16Office of the Law Revision Counsel. 26 U.S. Code 1223 – Holding Period of Property The stepped-up basis combined with automatic long-term rates makes inherited fund shares among the most favorably taxed assets in the code.