Autumn brings three things: cooler air, football, and capital gains and dividend income tabulations by mutual fund companies. So if you're considering buying or selling a fund between now and the end of the year, it's important to know if—and when—that fund plans a distribution.
Capital gains and dividend income distributions are the payments shareholders get when a fund sells its holdings at a profit, or passes along dividends or interest. You need to know if funds will pay a distribution because Uncle Sam will want his cut if you own those funds in taxable accounts. You also need to know the date your funds plan to make their distributions. The fiscal year ends on Oct. 31 for most fund companies, and they typically estimate their distributions after that date for payment sometime in December.
[See Know Yourself as an Investor.]
There are three key dates associated with distributions: record, “ex,” and payable. The record date determines which shareholders will receive a distribution. The following day is the “ex” date; shares trade at a value adjusted for the distribution. And companies pay distributions on the payable date.
Let's say you invested $10,000 in a mutual fund last year and decide to sell it after its record date. If the fund has net capital gains to distribute, you’ll get a capital gains distribution as a shareholder of record and face a tax hit. And if you use your proceeds to buy a new fund prior to its record date, you’d owe taxes on it, as well. There may be times you’re indifferent or uncertain about a fund. If it schedules a large distribution, your decision to hold or sell might be easier.
For example, if your $10,000 investment hasn't gained or lost value and you find out the fund anticipates making a long-term capital gains distribution of 15 cents per share, you may be better off selling the fund before the record date. If you have 1,000 shares, your distribution would be $150. If you’re in the 25 percent federal income tax bracket or higher, you’d owe more than $22 in federal taxes. Any other taxable distributions—including short-term capital gains— are considered ordinary income and taxed that way with one exception: qualified dividends. See below for more on tax rates for dividend income.
If you want to avoid the tax hit, you can move your money before the record date to a comparable fund not planning a large distribution. Of course, your decision might be different if the fund has lost or gained significant value.
Fortunately, capital gains and dividend income distributions aren’t state secrets. You can find out when fund companies plan distributions—and projected amounts—by checking their websites starting in mid-November. Your financial adviser can help determine the right time to buy or sell a fund without creating a tax hit. It’s important that your adviser also help you research and identify replacement funds that fit your investment plan if you sell.
The tax rates you pay on distributions depend on how long a fund owns the stocks or bonds that generated the gains. If a fund has held an investment a year or more, the gain is taxed at the capital gains tax rate and identified as a long-term gain on your 1099 form. Distributions of anything considered ordinary income—non-qualified dividends and income and gains from anything held less than a year—are taxed as ordinary income and reported as dividend income. Qualified dividends are taxed at your capital gains rate. And you're taxed on distributions whether you receive them in cash or use them to buy additional shares.
Not every fund distributes gains each year, and not all distributions are significant enough that you’d make a decision to buy or sell based on the amount. But it’s important you know about capital gains and dividend income distributions. A fund may make them even after a stretch where it has underperformed. If distributions are substantial enough in that instance, you might consider tax-loss harvesting.
[See Time for Tax-Loss Harvesting.]
If you're not sure you're buying or selling a fund at the right time, be sure to contact your adviser or tax expert for advice.
Adam Bold is the founder of The Mutual Fund Store, which provides fee-only investment advice with locations coast to coast. He's also host of The Mutual Fund Show, a call-in radio program broadcast across the country. Bold is author of the book The Bold Truth about Investing (April 2009). Bold is Chief Investment Officer of The Mutual Fund Research Center, an SEC-registered investment adviser, which provides mutual fund and asset allocation recommendations, and research to stores in The Mutual Fund Store system.