The Mutual Fund Tax Trap (& How To Steer Clear)
Many mutual funds pay out large capital gain, as well as, income distributions towards the end of the year. In fact, some funds have a history of paying out such earnings only at year-end rather than periodically throughout the year.
As a result, it's a good idea to plan ahead before you buy shares near the end of the year in a mutual fund that invests in equities (i.e., stock). This is especially true when the fund is about to pay a dividend. You might just be better off to wait until after the fund becomes what is known as "ex-dividend," meaning, after the record date of the dividend payout.
Why wait? Well, if you buy shares in a fund that is just about to pay a dividend but before the record date, you could in effect be buying the dividend; in other words, a part of what you are paying for the fund is in reality the value of the dividend to be paid out.
Further, because you are the one that actually receives the dividend, you get stuck with paying taxes on what amounts to some of your own capital, without any real increase in the value of your investment.
As lots of unsuspecting investors have learned the hard (and expensive) way, funds can have losses and still make distributions, some quite large.
Now here's the rub, and it can be a nasty one! A mutual fund's net asset value, i.e., its price per share, will drop by the amount declared as a capital gains distribution (which are profits from the sale of securities in the fund's portfolio) and by the amount declared as a distribution of income (e.g., dividends paid by securities it owns and interest earned on notes, bonds and similar assets).
These distributions of gains and income during the past year are paid only to those who own shares before the ex-dividend date.
What's the result of buying the fund just before the ex-dividend date? The investment effectively results in some of your own money coming right back to you as a distribution. You then have to foot the tax bill for that distribution!
This is true, even if you bought the shares just the day before the ex-dividend date. Your investment didn't grow and didn't earn the profits; rather you paid for them in the price of the shares you bought. But the tax is still yours to pay!
Here's an example that might make it clearer: In mid-December, let's say you pay $10,000 for 1,000 shares of GenX Fund, which sells for $10 a share. A day later, GenX declares a capital gains and income distribution of $1 a share, and you are set up to have that automatically reinvested in additional fund shares. Your fund holding remains worth about $10,000, assuming no other market-related changes occur. The consequences of the payout are:
- GenX's separation of the value of capital gains and dividends to be paid from the rest of its assets causes the net asset value of the share to automatically drop from $10 to $9 per share.
- You now own just over 1,111 shares.
- You also owe tax on the $1,000 distribution.
Assume the entire distribution is from qualifying dividends or long-term capital gains, and that you find yourself in the tax bracket where such income is taxed at 15%.
That means you now owe the IRS $150 on the distribution. You also likely owe state income tax on the distribution as well.
Had you invested the $10,000 after the GenX ex-dividend date, the results would have been quite different. Your delay would have allowed you to buy the same number of shares for $9 each without the $150 plus tax obligation.
What a difference a day makes, right?
By the way, if you already have money invested in funds, you also may be able to benefit from taking distributions into account when planning your end-of-year strategies. If you work with a broker or financial advisor, they should be able to help you with this.
The mutual fund companies themselves may also be able to provide information about year-end payouts, when they're going to declare distributions and how much those might be.
Own an IRA or other tax-qualified account? If so, you don't really have to concern yourself with the dividend date for investments in those accounts, since the account is not currently taxable and the payout of a distribution won't increase your tax liability.
