This is the time of year when investors start to take action by purging their underperforming mutual funds and ETFs and moving into better positioned, more highly-rated investments.
But if you are conducting your research to buy a fund or ETF and hold it in a taxable account, all of your diligent research can be upset if you fail to consider the drag of year-end distributions on your new fund purchase.
That’s because most fund families save the bulk of their capital gains and dividend income payouts until the end of the year. These payments are made to all shareholders of record as of a certain date, regardless of how long you have owned the fund. Shareholders are then responsible for paying taxes on those distributions.
So if you have owned a fund which delivered a healthy return over the year and have owned it for that long, you can expect to pay the year-end distribution. After all, those taxes are being applied to your total distributed fund gains. But if you are a new shareholder, who failed to notice the year-end distribution date, and bought the fund days before this declared date, you are now the proud owner of all the year-end distributions liability, even if you only owned the fund for a few days.
In some cases, new buyers of funds have been shocked to see the price of their newly-acquired fund drop up to 25% in one day. The reason: the fund paid its year-end distributions. That payment dropped the share price and the distributions were passed along to shareholders.
It also meant shareholders were liable for the tax on the distribution, so they paid a large tax now rather than in the future. If part of the distribution is short-term, this converts a long-term gain in the future into a short-term gain in the present. The problem is that short-term gains are taxed at a higher rate than long-term gains.
The realized gains inside the fund drive the year-end distributions. If the fund sells stocks for a gain, those gains must be distributed to the shareholders. The flip side of distributions is that shareholders can suffer an annual loss in their overall fund’s share price for the year and still be responsible for taxes in year-end distributions.
Watch for the Dates
To avoid this common year-end tax trap, contact the fund family or simply look at its Web site to see the “record date.” Many fund families regardless of their size, such as American Funds, Vanguard, Fidelity, Royce, and Westcore readily publicize their distribution calendars and record dates for specific funds or ETFs on their Web sites.
The record date states when the distribution liability is assigned. After that date has passed to the ex-dividend, or re-investment date, you can plan to make your new fund purchase. If you buy into the fund after the record date has passed, you will have the responsibility of paying any capital gains tax on the fund’s capital gains distribution next year.
Consider the Size of Distributions
It’s also important to consider the size of the expected year-end distribution. If a fund is scheduled to make a small year-end distribution in two weeks, waiting another two weeks may be penny wise and pound foolish. TFB, a blogger at thefinancebuff.com, warns that when the expected distribution is small, the market movement while you wait for the record date to pass can be many times the size of the tax effect on the distribution.