Tax bill shock – capital gain distribution

Tax season is just around the corner. Some of us might have received a tax bill shock from capital gain distribution.  

Let’s imagine this scenario. We are very careful and disciplined. We didn’t sell any securities in our investment margin accounts because we understand that it is taxable right away without the tax shelter RRSP and TFSA provide. We just buy and hold. We even purposely choose the type of security with more price appreciation and less interest or dividend. For example, Nadsdaq 100 index ETF. We thought that we made a smart move to minimize the tax bill. In January, we receive a big tax bill in thousands of dollars called capital gain distribution. What the heck? We didn’t sell anything at all. Where is this capital gain coming from. There is anger and frustration brewing already. Got to call the brokerage and find out first thing tomorrow morning! 😊

However, let’s do a simple search on internet and educate ourselves a bit first before we yelled at anyone innocent. 😊 Right away two good articles showed up. One is Understand capital gain distribution from moneysense.ca and the other is What is capital gain distribution and how it is taxed from investorpedia.com. Both are quite informative. I would highly recommend both. The first one is Canadian content and the second one is US. Just to summarize it below.

First of all, capital gain distribution is NOT capital gain. That’s why it is so confusing. Let’s use ZQQ Nasdaq 100 index fund as an example. Tech stocks are quite volatile, so some tech companies can be unicorn one day but fell out of favor the next and stock price decline.  Therefore, the index has to do some adjustments based on the market value of the biggest 100 non-financial companies listed on Nasdaq.  Then, the ETF fund companies have to sell those companies who got kicked out of the index which can result in capital gain if the selling price is higher than the book price when it was bought. The fund manager can decide to reinvest those cash and buy more share of other companies still on the index. However, this doesn’t increase the price of the ETF, or the number of units investors hold. The investors also didn’t receive any cash either. The only change is the book price increase for the investors because of this additional cash reinvested to the fund.

Nasdaq 100 index is quite volatile in terms of the list of companies in it thanks to the nature of the industry. A broad base index might be more stable and have less tax bill shock like this.