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THE JUNE 16, 2021, edition of The Washington Post carried this headline: “Cristiano Ronaldo snubbed Coca-Cola. The company’s market value fell $4 billion.”
The incident in question had occurred a few days earlier, at a press conference in Budapest, where the soccer star was set to play in a high-profile championship game. Coca-Cola was a sponsor of the tournament, so when Ronaldo sat down at the microphone, he found two bottles of Coke positioned in front of him.
Ronaldo wasted no time in moving the bottles out of the camera’s range. To make his point clear, he put a bottle of water down instead. “Agua,” he said in Portuguese. “No Coca-Cola.”
The press conference took place just as markets were opening in the U.S. and, as the Post reported it, “The simple gesture [of moving the bottles] had a swift and dramatic impact: The soft drink giant’s market value fell $4 billion.”
Coke’s share price did indeed drop that day. But in his book Trailblazers, Heroes & Crooks, Stephen Foerster offers a more careful examination of the incident. Looking at trading data, Foerster found that Coke’s share price had already declined before the press conference, and it actually rose afterward. In other words, Ronaldo didn’t cause the share price to drop.
What did? Stock prices can rise or fall for any number of reasons. But in this case, there was something specific. June 14, 2021, was what’s known as an “ex-dividend” date for Coca-Cola. This is an important but often overlooked dynamic that affects stocks and mutual funds.
When a company is getting ready to pay a dividend, it announces in advance the date that it will be paid. That’s called the “payable date.” For logistical reasons, it sets an earlier date as a cutoff for eligibility to receive that dividend. That earlier date is the ex-dividend date, or ex-date. The idea is that shareholders who own the stock on or before the ex-date will receive the upcoming dividend, while those who purchase the stock after the ex-date won’t.
As a result, all things being equal, stocks will typically fall on the ex-date by roughly the amount of the dividend. That’s because that cash is no longer in the company’s coffers and is thus no longer a part of its value. In the case of Coke’s stock on that ex-date in 2021, the drop wasn’t precisely equal to the dividend, but it was close.
This dynamic is more pronounced and more relevant when it comes to mutual funds and exchange-traded funds (ETFs). By law, mutual funds and ETFs are required to distribute the bulk of their income to shareholders on a pro-rata basis. A fund owning stocks, for example, is required to distribute all of the dividends generated by the fund’s stocks. Similarly, a fund owning bonds is required to distribute all the interest paid by its bonds. In this way, from a tax perspective, owning a fund isn’t too different from owning the individual investments in the fund.
Fund investors, however, face another category of taxes—one that holders of individual stocks and bonds don’t have to contend with. Fund shareholders also share in the capital gains generated within the fund. If the fund’s manager decides that he wants to sell one stock to buy another, and he sells the first stock at a gain, each shareholder in the fund will have to share in the resulting tax bill. And if that trade results in a short-term gain—taxable at a much higher rate—each shareholder will bear some of that cost.
As I described a few years back, these capital-gains distributions can have a surprisingly large—and adverse—impact. Because shareholders don’t know a fund’s trading plans, this tax bill is also generally unpredictable.
All that said, I always recommend investing in the stock market via mutual funds or ETFs, rather than buying individual stocks. But how can you guard against potentially negative tax results when investing in a fund? I have five recommendations:
1. While fund distributions are unpredictable and can vary from year to year, you can at least find out the date on which they’ll be paid. That way, you can avoid making a large investment just before a distribution is paid. This scenario is a problem for taxable-account investors because it means that a portion of their latest investment is immediately returned, along with a tax bill. Taxable investors will be on the hook for that tax bill even if they opt to reinvest the distribution in additional fund shares.
Consider a new investor in American Funds’ Growth Fund of America. Last December, that fund made a distribution equal to 6.9% of the fund’s value. You wouldn’t have wanted to invest in advance of this payment because it would’ve resulted in an immediate but avoidable tax. Distribution schedules are available on fund company websites. Here are links to the 2024 schedules for Vanguard Group and Fidelity Investments.
2. Funds like the Growth Fund of America tend to make sizable distributions because they’re actively managed, which means these funds can engage in significant trading that then results in realized capital gains. Some funds are even worse. In a recent roundup, Morningstar identified dozens of funds slated to distribute 10%, 20% or more of their value this year. Index funds, on the other hand, engage in far less trading, resulting in far fewer gains. Look through the distribution history of Vanguard’s popular Total Stock Market fund, for example, and you won’t find a single capital-gains distribution in the past 10 years.
3. Within the world of index-based investments, exchange-traded index funds tend to be the most tax-efficient, owing to their structure. I described this in some detail a few years back. Long story short, the difference between traditional mutual funds and ETFs is that ETFs are baskets of stocks that are traded among investors but are almost never sold. Result: They generate very little, if anything, in the way of capital-gains distributions. The idea of a 6.9% distribution, like the one described above, would be unheard of for most ETFs.
4. If, for whatever reason, you choose to invest in an actively managed fund, check its historical distribution rate. Look back several years to see what distributions have looked like during both up and down years in the market. If a fund has a history of being tax-inefficient, and you still want to invest in it, try to make the purchase in a retirement account, where the distributions won’t be taxable in the year they’re paid.
5. Regardless of the type of fund you choose, don’t automatically reinvest distributions back into the fund, even in a retirement account. This is often a default setting, but it can cause unforeseen results. The wash sale rule, for example, can cause a negative tax result under certain scenarios.
A final note: Some funds carry very high distribution rates and advertise it as a feature. Here’s how T. Rowe Price describes its Retirement Income 2020 Fund: “Turn your investments into automatic income…. The fund’s managed payout strategy is designed to provide a stream of predictable monthly distributions throughout retirement, targeting 5% annually.”
Funds like this, however, are playing a bit of a shell game, in my view. That’s because they employ another kind of distribution known as a return of capital. As its name suggests, these distributions are simply returning a portion of a shareholder’s investment. They don’t represent income or capital gains. It’s as if you handed a fund company $100, and it turned around and handed $5 back to you. I see this as a gimmick. These return-of-capital distributions are shown on T. Rowe’s website. It isn’t the only fund company that does this sort of thing.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
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You forgot the easiest and most effective: Pile as much of your equity pile into tax-deferred regular and Roth IRAs as possible.
Capital gains distributions can be very frustrating, even if you can find out they are coming in November or early December. They stick out in your tax calculations. They are occasionally so large that they disrupt your tax planning, and push some of your income into the next higher bracket.
But Uncle Sam would be getting his money eventually anyway (barring your death and the step-up in basis your heirs would get.) So, I just shrug my shoulders and recognize I’ll just have to cut off another slice of my checking account balance to send to the IRS, sooner rather than later.
I guess I could move some of the offending funds over to ETFs, but I am still more old school. I remain comfortable with the index mutual fund as a product. There is something about the potential for a daily rush with ETFs that worries me, even though it shouldn’t.
This is why individual stocks are good – at least you know when you’re selling something and taking a capital gain.
Point #5, on the wash sale rule, has prompted some questions, so I wanted to provide a further explanation.
The wash sale rule is relevant when an investor sells a stock, bond, mutual fund or other investment at a loss in a taxable account. Ordinarily, selling an investment at a loss would provide a tax benefit. It could be used to offset other gains, or if there are no other gains that year, then up to $3,000 of the loss can be applied against ordinary income, such as wages.
However, if the investor has purchased the same or a “substantially identical” security within 30 days before or after the sale, then the investor can’t take the loss for tax purposes at that time. The loss can only be used at a later time, when the entire position is ultimately sold.
Here’s an example: Suppose an investor buys 10 shares of a mutual fund on January 1 and purchases additional 5 shares on June 1. Then on June 15, he notices that the share price has declined. He can sell his original 10 shares from January, but due to the wash sale rule, the loss won’t provide a tax benefit because of the shares he had purchased on June 1 (i.e., within 30 days). This investor can only book the loss for tax purposes after he has sold all 15 shares.
If a mutual fund is set up to automatically reinvest dividends, it can inadvertently cause wash sale violations, because additional shares are being purchased regularly. If an investor wants to sell some of his shares at a loss, he’ll need to check carefully that there hasn’t been a dividend reinvestment within the prior 30 days and also needs to make sure that a dividend reinvestment doesn’t happen within 30 days after his sale.
Importantly, the wash sale rule applies across all of an investor’s accounts, including retirement accounts. If the same fund were held in both a retirement account and a taxable account, then a dividend reinvestment in a retirement account could cause a wash sale problem in a taxable account. That’s why I recommend disabling automatic reinvestments even in retirement accounts.
In other words, the wash sale rule is complicated, and automatic reinvestment of distributions makes it that much more complicated!
Health savings accounts aren’t included when considering wash sales, are they?
Michael Perry, no relation to me, wrote a good Humble Dollar article on pitfalls of wash sales in 2023 with commentary that reinforces Adam’s idea of considering turning off dividend re-investments.
https://humbledollar.com/2023/02/profiting-from-losses/
Thanks for remembering that William. Reading back, I must not have realized at the time I wrote it that not only can a purchase in any of one’s own accounts result in a wash sale, but also a purchase in any of a spouse’s accounts.
Adam, thanks for an excellent article. It’s a timely reminder of the need to understand what we are investing in. I recall, many decades ago, being quite surprised by a fund’s year-end distribution and the ensuing tax bill.
I recently realized I overlooked an ETF I own in my taxable account that paid ordinary quarterly dividends instead of qualified. I found my error when viewing the YTD tax activity on my brokerage account and then confirming it with the prospectus for the magic words.
And try to explain to someone having their taxes done, why they have taxable income when they didn’t sell anything… Especially during a bear market when investments are taking a beating.