December is the most dangerous time of the year for investors who own mutual funds in taxable accounts.* Here are some basics concerning taxes and mutual funds that can help you navigate what otherwise can be a tricky and confusing month.
(*Note that investors in tax-advantaged accounts such as IRAs, 401(k)s, and 403(b)s are not impacted by fund distributions. Fund distributions typically affect only investors using taxable accounts.)
Mutual funds, as they invest their shareholders’ money throughout the year, incur capital gains and losses. They also receive dividend and interest income. From a tax point of view, all of this is done on behalf of shareholders. It’s as if you owned all the investments outright, and the gains and losses that result are all your personal gains and losses. There are three ways this happens:
- Funds invest in stocks that pay dividends. The funds collect the dividends and pay them to you periodically.
- Funds invest in bonds or other debt securities that pay interest. They collect the interest and pay it out periodically.
- Funds sell one of their investments for more than they paid for it, thereby reaping a capital gain. They keep track of these gains (and offset them against any capital losses), and pay them out to you periodically.
All of these payments to you are called “distributions.” The fund decides whether to make these periodic distribution payments monthly, quarterly, semiannually, or annually. The amount you receive depends on how many shares you own.
A fund goes through a two-step process in making distributions. First, it “declares” the amount of the distribution it intends to make, and sets aside the necessary cash. This has the effect of suddenly lowering the net asset value of the fund — one day the money is being counted as part of the fund, and the next day, the day of the declaration, it isn’t.
This sudden drop in value startles inexperienced investors because they mistakenly think that money has been lost. It hasn’t — it’s merely being removed from the fund so it can be paid out to you. The date this declaration happens is called the “ex-dividend” date, and is the significant date as far as your taxes are concerned.
The second step of the distribution process is when the fund actually mails your check. This is called the “payment date” but has no significance when computing your taxable income. Now let’s look at two common misconceptions that investors have about mutual-fund taxation.
- Misconception #1: “As long as I don’t sell any of my mutual-fund shares, I won’t have any capital gains taxes to pay.” The mutual fund, within its portfolio, is continually buying and selling securities. Each time it sells one, it creates another capital gain or loss. You participate in your fair share of these gains or losses at the time the fund declares a capital-gain distribution, and will owe tax on that distribution, regardless of whether you’ve sold any shares.
Separate from any distributions, when you eventually do sell your fund shares, any capital gain or loss must be reported on Schedule D of your form 1040 tax return just like any other investment. One easy way to delay paying this capital-gains tax is to avoid selling mutual funds for gain just before the end of the year. If you sell near year-end, taxes will have to be paid by April 15, just a few months later. Instead, you might wait to sell until the first week of January. The tax on such gains would then not be owed until April 2019. (By the same token, a good time to sell a fund at a loss is in December, as the loss will be deductible on the tax return filed next April.)
- Misconception #2: “It’s a good idea to invest in a mutual fund just before one of its periodic distributions.” Actually, it’s a bad idea for investors in taxable accounts because it will create an immediate tax liability. If an investor buys a fund today and the fund declares a distribution tomorrow, the investor owes tax on the amount of the distribution. There is no additional benefit to owning a fund on the ex-dividend date because the amount the shareholders receive is deducted from the value of the fund that same day.
Most funds make distributions at roughly the same time each year (December is the busiest month of all), and usually can tell you ahead of time when they will happen. This presents an opportunity for savings. Before making a major purchase of shares in any mutual fund, check (1) if a distribution will be made soon, and (2) what is the fund’s estimate of the amount. Most funds post this information on their website. If a distribution is scheduled soon, you have the option of waiting to purchase your shares until after the distribution to avoid its tax impact.
Most investors likely didn’t receive significant distributions last year, due to the pair of market corrections in late-2015 and early-2016 offsetting any gains. But given the big gains most stock funds have had in 2017, significant distributions this year are likely. If you’re following SMI’s strategies in a taxable account (Stock Upgrading is the strategy where this is most likely to apply), paying attention to these distribution dates can save you money at tax time — or at least delay the paying of those taxes for another year.
One cautionary note: A preoccupation with taxes can end up being counterproductive. Sometimes a few days in the market can make a big difference in the price you pay or receive for your shares. Don’t let tax considerations become the overriding factor in your investing decisions.