Like mutual funds, closed-end funds pay out their earnings to shareholders in two ways:
Income dividends pass through to shareholders the interest or dividends collected by the fund, net of expenses. Fixed income closed-end funds typically pay out income dividends monthly or quarterly, while equity funds pay out income dividends quarterly, semi-annually or annually. Income dividends generally are taxable to shareholders as ordinary income, provided shares are held in taxable accounts. Income dividends paid by municipal bond funds are, of course, exempt from certain taxes.
Capital gains distributions pass through to shareholders the "realized" capital gains of the fund, net of realized capital losses. As long as a security is held in the fund portfolio, any gain or loss is considered to be "unrealized." A gain or loss becomes "realized" only when the fund sells shares. Most closed-end funds make capital gains distributions once each year, toward the end of the calendar year. The portion of a capital gains distribution reported by the fund as "short-term" generally is taxed to shareholders as ordinary income (in taxable accounts). The portion reported as "long-term" is taxed to shareholders at 0%, 15% or 20% depending on your income level, under current law.
By reinvesting distributions rather than taking them in cash, the shareholder is able to compound the return as invested capital.