More on Fund Distributions and Taxes
By David Harrell
Here?s something that can send a fund investor into cardiac arrest: You pick up a newspaper or fire up a Web browser to check the returns on your mutual fund and you see that its NAV has dropped from $25 to $20, even though the market was up for the day. What went wrong?
Was it an ill-timed currency hedge, some sort of exotic derivative, or did a large position in a micro-cap stock implode? Perhaps, but the most likely explanation is that your fund made a capital-gains distribution. If so, you haven't lost anything, at least not yet.
By law, mutual funds must distribute to their shareholders substantially all of their realized capital gains that are not offset by realized losses by the end of their accounting year. (Otherwise, the fund itself would become liable for the taxes.) Mutual funds ?realize? a capital gain whenever they sell a security for more money than they paid for it. Conversely, they realize losses anytime they sell a security for less than the purchase price. If the gains outweigh the losses, the fund must distribute the difference. When this happens, your fund company will issue you a check for the distribution amount multiplied by the number of shares that you own. Or, if you?ve selected the reinvestment option, the fund company will instead use the money to buy more shares of the fund. After the distribution is made, the fund?s NAV will drop by the same amount as the distribution. Fund companies often make capital-gains distributions in December, but they can happen at any point during the year.
Another type of distribution that mutual funds can make is an income distribution. Obviously, a fixed-income fund that owns bonds will be paying out lots of income, and a stock fund that owns dividend-producing stocks will also pay out those dividends. While the NAVs of fixed-income funds are adjusted daily for income distributions, the NAVs of stock funds do drop when income distributions are made. However, income distributions are relatively small for the majority of stock funds, so any NAV changes that result are less likely to cause heart palpitations.
So What Difference Does It Make?
As we mentioned earlier, even though your fund?s NAV may have dropped dramatically after a capital-gains distribution, it doesn't mean that you've lost any money: Instead of owning a share of a mutual fund that is worth $25, you now have a share that is worth $20, plus a check for $5. Or, more commonly, if you'd opted to have your distributions reinvested, you'd now have 1.25 shares of a fund that is worth $20 per share.
However, there is a catch to all of this: After the distribution is made, unless you own the fund through a 401(k) plan, an IRA, or some other type of tax-deferred account, you owe taxes on the $5, even if you opted to reinvest it. With the recent changes in the capital-gains laws, the tax bite isn't as bad as it could have been in years past, but it can still be substantial. And it hurts the most if you just recently purchased the fund. Let's use our example to illustrate.
Suppose you invest $250 in Acme Growth Fund on Monday. The fund's NAV is $25, so you're able to buy 10 shares. If the fund makes a $5-per-share distribution on Tuesday, and you reinvest, your investment is still worth the same $250:
Monday 10 shares @ $25 = $250
Tuesday 12.5 shares @ $20 = $250
The trouble is, you now owe capital gains taxes on that $50 dollar distribution. We'll assume that they are long-term gains, taxed at 20%, which would result in a tax bill of $10.
Of course, if you immediately sold the fund, the whole thing would be a wash, as the capital gains would be offset by a capital loss. And, because the distribution lowers the NAV, it does reduce the amount of taxes you would pay if you sold the fund years from now. Still, most investors would rather pay taxes later than sooner.
Avoiding the Tax Man
While you can take some solace in the fact that you're being taxed on your gains, fund companies occasionally can add insult to injury by paying out a large capital gains distribution in a year in which the fund lost money. Last year, for example, most emerging-markets funds made capital-gains distributions, even though many of them were in the red for the year. And sometimes investors can have some funny ideas about distributions. A couple of years ago, Fidelity Magellan, the country's largest mutual fund, made headlines when it revealed that an expected distribution wasn't going to be made after all. Some shareholders expressed concern that something had gone wrong, but the lack of a distribution was actually in their favor. A capital-gains distribution doesn't increase the value of your investment, but it does result in taxes. If needed, you always have the option of creating your own "distribution" by selling some of your shares.
If you're thinking about investing in a new fund, always give the fund company a call first, especially toward the end of the year. They'll be able to tell you if a distribution is imminent. And, for the complete lowdown on avoiding unwanted capital-gains distributions, check out Year-end Tax Traps and Will Your Fund Say "Gotcha"? in our Plan area. Finally, some fund companies are now offering tax-managed funds, which are run in such a way as to minimize the amount of taxable distributions.