As the year is coming to a close, there is one thing that is bound to occur around the middle of December: your mutual fund or funds will distribute their accumulated capital gains to their shareholders. If you own mutual funds in a taxable account, you owe taxes on those distributions whether the distributions are paid out in cash or reinvested in additional shares. The funds report distributions to shareholders on IRS Form 1099-DIV after the end of each calendar year.
One way to minimize your income tax liability is to delay purchasing mutual fund shares until after the date dividends or capital gains are distributed to shareholders. If you purchase mutual fund shares just before a distribution is made, the total value of your investment will remain the same, but your current year tax liability may increase.
Here’s why. Just before a mutual fund makes a distribution, the share price includes the amount of dividend or capital gain that is about to be distributed. Once the amount is distributed, the price of your shares is reduced by the amount of the distribution to you divided by the number of shares you owned before the distribution. Whether you reinvest the dividend or capital gain or receive it in cash, the value of your investment (including cash) remains the same. However, you may owe current taxes on the amount of the distribution. The following example illustrates this strategy:
Margaret had $1,400 to invest and purchased 100 shares in a mutual fund one day before the fund was set to distribute dividends. The cost per share was $14. The next day, the fund distributed $1 per share, which Margaret reinvested. Because the share price was then only $13 per share (due to the distribution, assuming market factors remained neutral), she was able to purchase approximately 7.692 additional shares with the $100 she reinvested. Even though Margaret now owned more shares, the value of her investment remained the same at $1,400 (107.692 shares x $13/share) because the price per share was lower. However, the $100 distribution she received increased her income tax liability for that year. Had Margaret instead waited to purchase shares until one day after the fund distributed dividends, the value of her investment would have been the same, but she would have incurred no additional current year tax liability.
Find Out When Distributions are Scheduled
In order to delay purchasing mutual fund shares until after a distribution, you should find out when distributions are scheduled. Mutual funds must make distributions at least once per year, but may distribute gains and income monthly or quarterly. Equity mutual funds are the exception; they usually make annual year-end distributions in December. Tax planning for specific types of investments can minimize your tax liability.
The amount of tax liability you incur depends on whether your distribution is taxed as ordinary income or as long- or short-term capital gains. It also depends on your marginal tax bracket. You will receive a 1099-DIV form from the fund company reporting the amount and type of distribution (e.g., ordinary income, capital gain) in January of the following year.
Provided by Ed Wettig, CFP, Wettig Capital Management which offers investment management, financial planning and retirement income strategies. Securities and investment advisory services offered through Royal Alliance Associates, Inc. Member FINRA/SIPC and a Registered Investment Advisor. Wettig Capital Management is independent of Royal Alliance Associates, Inc. and not registered as a broker/dealer or investment advisor.
