Article
written by EricBank
If you are considering the purchase of
mutual fund shares in the last couple of months of the year, you might want to
time your transaction to avoid the fund's year-end distributions. Otherwise,
you'll be paying the taxes on those distributions on April 15 of the following
year, without any compensating benefit.
Mutual
Fund Distributions
Mutual funds are pass-through entities: as
long as they pay out substantially all of their annual income, they pass the
tax obligation onto you, the shareholder. A mutual fund portfolio has three
income sources:
1. Dividends it receives
on the shares it owns
2. Interest it receives
on the fixed income instruments it owns
3. Capital gains on the
profitable sale of securities
Funds must distribute at least 90 percent
of dividends and interest, and 98 percent of capital gains, to avoid excise
taxes on the undistributed amounts.
Capital
Gains Distributions
The convention is for funds to make annual
capital gains distribution in November or, more likely, December. Funds
normally announce the record date and amount per share a few weeks in advance.
Shareholders at the close of the record date receive the distribution (and in
taxable accounts, its accompanying tax obligation). The distribution is not
prorated for the amount of time you held the shares beforehand -- you receive
the full distribution. One day after the record date, the fund shares trade
ex-dividend, their net asset values reduced by the distribution amount. The
actual payment occurs a few weeks later, on the payment date -- a date that has
no tax significance.
Tax
Strategies
Here are some strategies to help you avoid
the year-end tax consequences of mutual fund capital gains distributions.
- Ascertain the record date and distribution amount from the fund before buying shares late in the year. If the distribution amount is more than de minimus, wait until the ex-dividend date to make your purchase.
- Before the record date, sell shares that are priced below your acquisition cost. You can take a loss on those shares and avoid the capital gains distribution on them.
- If you are an index trader, consider using index ETFs instead of index mutual funds. ETFs follow special procedures, called the creation/redemption mechanism, mainly to ensure that the share price is kept very close to the share net asset value. However, another benefit of this mechanism is that it frequently allows the ETF to shed profitable shares tax-free. Some index ETFs haven't paid capital gain distributions in years. Another factor for active traders: you can sell ETF shares at any time -- open-end mutual fund companies sell and redeem share after trading hours. Therefore, ETFs are more suitable to active traders, especially day traders.
- Because most mutual fund shares are held for investment, it makes sense to park those shares in an IRA or other non-taxable account. If you use a Roth account and follow the rules, you can avoid taxes on all withdrawals.
- Most stock dividends qualify for capital gains rates, and that includes stock dividend distributions from mutual funds. However, any distribution of stock dividends you receive from mutual fund shares that you hold for investment will be subject to ordinary tax rates if you fail to hold those shares for at least 61 days surrounding the ex-dividend date.
