[Editor’s note: Even though the market is up strongly in recent years, 2018 saw two substantial sell-offs. That’s why mutual fund “distributions” are likely to be a significant event this year. During those sell-offs, some funds sold long-held winning positions. The gains from those sales must be distributed to investors.]
It’s not unusual for new readers to become concerned when one of our recommended funds suffers what appears to be a severe one-day decline! We assure them there’s no cause for alarm: the drop was caused by a fund distribution.
Let’s review the basics of mutual fund distributions (for more details, see Beware the Mutual Funds’ End-of-the-Year Tax Trap). In the process of investing, mutual funds incur capital gains and losses, and they receive dividend and interest income on their investments. 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:
- A fund invests in stocks that pay dividends. It collects the dividends and pays them out to you periodically.
- A fund invests in bonds or other debt securities that pay interest. It pays the interest out periodically.
- A fund sells an investment for more than it paid, thereby earning a capital gain. The fund keeps track of such gains (and offsets them against any losses), and pays them out periodically, usually once a year.
All of these payments to you are called distributions, and the amount you receive will depend on how many shares you own. A fund company decides whether to make these periodic distribution payments monthly, quarterly, semiannually, or annually.
Making distributions is a two-step process. First, the fund company “declares” the amount of the distribution it intends to make, and sets aside the appropriate amount of cash that will be needed to write you a check (or deposit money in your account). This has the effect of suddenly lowering the net asset value (NAV) 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 understandably startles inexperienced investors. They may think the money has been lost! It hasn’t — it’s merely being removed from the fund so it can be paid out to all the fund’s investors. The date this declaration happens is called the “ex-dividend” date. It is the significant date as far as computing one’s tax liability is concerned. The second step of the distribution process is when the fund actually makes the distribution (either by check or electronic transfer).
Most funds issue distributions at roughly the same time each year (December is the busiest month of all). Typically, a fund company will tell you ahead of time when a distribution will happen, often by publishing that information on the fund’s website. If you’re investing in a taxable account, knowing ahead of time when a distribution will be declared presents an opportunity for tax savings.
Before making a major purchase of shares in any mutual fund, check the fund company’s website to see (1) if a distribution will be made soon, and (2) if there is an estimate of the amount. (If you don’t find this information on the website, call the company.) If a distribution is scheduled soon, you can avoid its tax impact by waiting to purchase your shares until the day after the distribution.
You also can use this information to move up the sale of any holdings you plan to sell in January anyway for rebalancing reasons. By making a before-distribution sale of any positions that are worth less than your purchase price, you’ll avoid a distribution and also book a loss that may offset other gains on your 2018 tax return. (On the other hand, if you earn a profit — i.e., you sell your shares before year’s end for more than you paid for them — you’ll have to pay capital gains tax on your profit by next April 15.)
One cautionary note: A preoccupation with taxes can end up being counterproductive. In investing, a few days can sometimes make a big difference in the price you pay (or receive). Don’t let tax considerations become the overriding factor in your buy/sell decisions.