End-of-Year Mutual Fund Considerations

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.