For investors in mutual funds, the receipt of distributions from mutual funds in December should be a normal activity. However, in recent years many of these distributions were eliminated due to market performance. I have reviewed the estimated distribution amounts for a number of mutual fund families for the 2010 end-of-year activity. While some funds are restoring capital gain distributions, most are still anticipating no capital gain distributions for this year.
You may wonder what this means to the performance and potentially the tax impact. Actual distributions are used in the calculation of annual performance, but whether there is a distribution or not does not improve or hurt performance. I am often asked whether it is smart to purchase a mutual fund in advance of an expected distribution. The answer is clearly no. Ignoring the change in value for the investment on any particular day, a distribution from a mutual fund is similar to changing a twenty dollar bill into a ten and two fives. The value is the same before and after the transaction.
As an example, a twenty dollar per share mutual fund paying a $1.20 in dividends will be worth $18.80 after the dividends are paid. The fund calculates it share value at the end of the day including the cash which is about to be used for the dividend distribution. Once the cash is set aside for the dividends, a new share value is calculated and this new value is what is used for the reinvested dividends and the value after the dividends have been paid out. Thus, the value of the dividend paid plus the new value of the shares will equal the value prior to the payment.
For taxable accounts which incur a dividend shortly after purchasing shares creates taxable income. If the fund has yet to go up in value, having to pay tax on this income is not very desirable. Therefore, it is generally best to purchase mutual funds for taxable accounts after significant distributions have been made.
Mutual fund companies are required to distribute to the shareholders most of their realized income each calendar year. Due to the tremendous drop in the value of investments during the recent recession, many equity mutual funds have losses they can continue to use to offset gains taken this last year. Once the realized gains exceed the fund’s losses, the fund will once again be required to distribute these gains.
For Tennesseans, there is an opportunity to reduce their annual tax bill. For taxable investment accounts, the Tennessee Halls Tax taxes all dividends from mutual funds including capital gain distributions. If the fund is held and the dividends are received, then the six percent Halls tax may have to be paid. However, if the mutual fund is sold and a gain is calculated based upon sales price less the tax basis in the fund, this gain is not subject to the Halls tax. The proceeds can be reinvested in a new mutual fund, but the investor should avoid buying back into the fund they just sold for at least 31 days, and they should avoid purchasing a new fund which is about to pay dividends. This type of transaction is not always the best move, but should be considered when a mutual fund is about to pay a large per share capital gain distribution.
With the recent recovery in many of the equity indexes, many mutual funds should return to paying capital gain distributions during 2011, if not sooner.
For assistance with portfolio allocations, insurance, estate planning, or investment management contact me at Quality Financial Concepts or one of the other Certified Financial Planners in our area. To continue a personal quest for education, you can also view our learning center on our website, www.goqfc.com. There you will find articles on a variety of topics, on-line seminars, calculators, as well as a host of other free tools.