One common mistake investors make is buying mutual funds just before they pay out dividends and capital gains. At first, buying before a distribution seems like a great idea. Most people look at it as free money and assume you get to collect income from the fund immediately after buying. Unfortunately, it doesn’t work that way. In fact, using a taxable account to buy a fund before it makes a distribution can actually cost you money.
- Mutual funds pay distributions through dividends or capital gains.
- With either method, a distribution lowers the net asset value.
- Each distribution method is taxable, but the amount of tax depends on how long the investments have been held.
- Buying a fund right before it pays a dividend triggers taxes that you must pay before you can reinvest, causing a loss.
The Mechanics of Mutual Fund Distributions
The way funds pay their distributions is slightly complex, but it’s important to understand how they work so that you can avoid unnecessary headaches. There are two types of distributions: dividends and capital gains.
With dividends, funds collect income from their holdings, and they retain this income until they pay it out to shareholders. With bond funds, this income is typically passed along to investors once a month; in a stock fund, payouts can occur once, twice, or four times a year. When the funds earn this income and hold it before the distribution, it is reflected in the fund’s net asset value (NAV).
For instance, when a fund with a total value of $1,000,000 and 100,000 shares collects $50,000 in dividend income, its NAV rises from $10.00 to $10.05. When the fund passes this dividend income to shareholders, that money comes out of the fund, and the NAV drops to reflect that change.
As a result, the investor receives $.05 per share in dividends, but the NAV drops back to $10.00. In short, while the investor received income, the total value of her account is the same on the day after the dividend as it was the day before the dividend.
Capital gains work essentially the same way. When a fund sells an investment at a profit, it locks in a capital gain. If the total amount of capital gains exceeds the value of capital losses at year's end, the fund must pass on the net proceeds to shareholders.
If you're buying into a fund to hold it for the long-term, you can save a little in tax dollars by waiting to purchase it after the dividend is paid out.
As with dividends, these gains are already reflected in the fund’s net asset value before the distribution. And, in the same way, when the capital gains payout occurs, the fund’s share price drops to reflect the cash that is removed from the fund and sent to shareholders.
In other words, a $5 capital gain is accompanied by a $5 drop in the share price. The result is also the same as with the dividend payout: the total value of the capital gain is the same on the day after the dividend as it was the day before the capital gain.
It means that investors don’t “make” money on the day of the payout. This money has already been made throughout the year and is gradually reflected in the fund’s share price. That’s why any effort to buy before a distribution to “capture” the dividend is futile—in the end, the value of the investor’s holding remains the same.
The Impact of Taxes
Unfortunately, there’s more to the story. Investors have to pay taxes on these dividends and capital gains in “regular” or taxable accounts, unlike distributions in a 401(k) or IRA. In taxable accounts, the investor doesn’t get to keep all of the distribution—they have to give up a portion for taxes.
Dividends and short-term capital gains are taxed as regular income, while long-term capital gains are taxed at the appropriate capital gains rate.
You have to have held an investment for more than one year for profit from its sale to be a capital gain. Otherwise, the profit is normal income.
Consider this example. An investor with a $10,000 account on December 28 receives distributions worth $500. The next day, they reinvest the proceeds into the fund. The position is still worth $10,000, but if their tax rate is 28%, that $500 is reduced to $360 ($500 minus $140) on an after-tax basis. The investor loses that portion of the account's total value in the form of the payment of the applicable federal income tax.
Be Aware of the Timing
The tax bite isn’t a reason not to invest—after all, paying taxes means that you have made money. Dividends and capital gains represent money that the fund made during the year, and for shareholders who have held the asset all year, that’s fine.
But for investors who are new to a fund, there’s no reason to buy shares shortly before the distribution. In essence, you’re paying unnecessary taxes on money that you haven’t actually made. It’s therefore essential to be aware of the timing of upcoming distributions when making a new investment or putting new money into a fund you already own.
This isn’t as much of a problem with bond funds, since distributions almost always occur each month, and capital gains are relatively small. However, income-oriented investors who also hold stock funds searching for higher returns need to be particularly aware of this issue.
Most funds pay out capital gains in the final week of December, but there is a handful that makes distributions at other times of the year. Keep in mind, then, that this isn’t an issue specific to the fourth calendar quarter—you should always check a fund’s payout history to make sure it isn’t about to pay a distribution.
Mutual fund strategies will be best suited for different individuals based on their particular circumstances and goals. For example, retirees may prefer to use the cash distributions from mutual fund dividends as personal income and not necessarily for reinvestment purposes to maximize longer-term gains.