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IT’S LATE NOVEMBER. Is there anything you can still do to trim your 2019 tax bill? There might be. One overlooked aspect of mutual funds is how they can significantly—though quietly—impact shareholders’ tax returns.
By way of background, mutual funds—including exchange-traded funds (ETFs)—are required to pay out to shareholders, on a pro-rata basis, all of the income that they generate each year. This includes interest paid by bonds, dividends paid by stocks and capital gains created when a fund sells an investment at a profit.
Suppose you’re a fund shareholder—and suppose the fund bought a share of Apple stock on Jan. 1, held it for 10 months, and then sold it at the end of October. How much income would this investment have generated for the fund and therefore how much would it be required to pay out to you, as a shareholder?
During those 10 months, Apple paid dividends of $3.04 per share. Meanwhile, between the purchase and the sale, Apple’s share price increased from $157.92 to $248.76, for a profit of $90.84. As a result, the fund’s total income from this investment was:
By law, this fund would be required to pay out that $93.88 to its shareholders by the end of this year, along with the net gains from all of its other investments, minus the fund’s operating expenses.
This may seem discouraging: Your tax bill is in the hands of your fund manager, who’s permitted to buy and sell freely, generating tax headaches for you. But there are three important facts to know, so you can take back control of this situation:
1. Some funds are far more tax-efficient than others. Broadly diversified index funds have many well-known advantages, including strong performance. But a lesser-known advantage is that they are, almost universally, more tax-efficient than their actively managed peers.
Why? Index funds, for the most part, employ a buy-and-hold strategy. They don’t see the same sort of trading activity as funds run by stock-pickers. This translates into fewer capital gains and thus smaller tax bills for you, the shareholder. This is yet another reason to favor simple index funds like S&P 500 funds and total U.S. stock market funds.
According to an analysis by the research firm Morningstar, this effect has been amplified in recent years. As investors have moved billions out of actively managed funds and into index funds, it’s put selling pressure on many actively managed funds. To pay the money owed to departing shareholders, these fund managers have been forced to sell some of their holdings, triggering gains. With the market at new highs, and actively managed funds losing popularity, I expect this trend to continue.
True, the tax bills generated by actively managed funds are often modest. Problem is, they’re also entirely unpredictable. In that same analysis by Morningstar, the firm relates how one well-regarded fund—the Sequoia Fund—ran into trouble. The fund manager had become enamored of a company called Valeant Pharmaceuticals, to the point where it accounted for nearly 30% of the fund’s assets. Unfortunately, Valeant got caught up in a series of scandals, destroying the stock’s value. Investors fled. That forced the fund manager to begin selling the fund’s other investments. In the end, the Sequoia Fund has lost nearly half its value since 2015. To add insult to injury, it has left shareholders with massive tax bills. This is an extreme example. Still, it illustrates why investing in an actively managed fund is like handing a blank check to your fund manager.
2. Even if you currently own an actively managed fund, you might still be able to sidestep a big part of this year’s tax bill—if you act quickly. This time of year, many fund companies publish “distribution” estimates for each of their funds. For example, you can find Vanguard’s distribution estimates listed here and Fidelity’s here. Not only will they tell you the projected size of the distributions, but also they’ll tell you the exact date on which they’ll be making those distributions—called the “pay date.”
Don’t like what you see? The good news is, you can avoid receiving your share of a taxable distribution by simply selling the fund before the “ex-dividend” date. You want to make this decision carefully, to confirm that selling aligns with your overall investment plan and to be sure that it doesn’t generate other, unexpected taxes. For instance, even if you can avoid the distribution by selling, you might trigger an even larger tax bill—because you’ll owe capital-gains taxes if your fund shares are worth more today than your cost basis. The latter will consist of the money you’ve invested over the years, plus any fund distributions that you reinvested in additional fund shares.
3. The above discussion applies only to taxable accounts. If you own a fund inside a retirement account, like an IRA or 401(k), these kinds of distributions wouldn’t affect you. Don’t like an actively managed fund that you own? In a retirement account, there’s no tax cost if you sell.
Adam M. Grossman’s previous articles include No Comparison, A Graceful Exit and Time Out. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.
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What matters is the record date (or if you prefer, the ex-date, as the two are linked), not the pay date. So long as you don’t own the shares on the record date, you don’t get the dividend.
Sometimes the amount of unrealized gain you have in your shares is less than the projected distribution (ordinary income and cap gains combined). This is more likely to happen in a down year than in a year like 2019.
If that does happen, you can sell shares to avoid the dividend, recognize the smaller cap gain, and then repurchase the shares on or after the ex-date. So selling ahead of a dividend can sometimes be done without impacting your investment plan. I’ve done this.
However, if your intent is to sell shares and not repurchase them, you may wind up not sidestepping any taxes. You might even increase them.
If you sell before a distribution you’ll recognize some amount of cap gains on your shares. But if you sell after a distribution, the share price will have dropped by the amount of the distribution. So you’ll recognize a cap gain reduced by the same amount as the distribution you receive. No change in net income.
What does change is the character of that income. Take the distribution and you get a mix of qualified divs, nonqualified divs, and cap gains. Sell before the distribution and you recognize that same income in the form of higher cap gains. Those gains might be short term or long term, depending on how long you held your fund shares.
Best case: you sidestep nonqualified divs and take the income in the form of higher long term gains (on the shares you sold). Worst case: you sidestep a cap gains distribution and convert that income into short term gains (on the shares you sold).