Tax Tactics for Mutual Fund Distributions

November 15, 2012

Earlier this week, we explained that it is rarely worth selling a fund to avoid a long-term distribution — that’s why we’d continue holding Class 2 Parnassus (PARNX), despite that PARNX is expected to make a large (6.5%) distribution of long-term capital gains on November 16. Today, we show why some investors might consider selling a fund after it has made a distribution.

Consider this scenario, and three ways you might proceed:

Let’s say PARNX has the exact same price you paid for it six months ago — zero gain and zero loss — and you won’t incur any redemption fees if you choose to sell the fund to avoid its distribution. You could:

1. Sell the fund just before the distribution, with zero gain and zero tax hit, and move on to another highly ranked Class 2 fund.  (Be aware that a fund you buy now may make its own distribution next month, and you may be locked into that fund if you just bought it.)

2. Hold the fund, receive the distribution (which you would immediately reinvest as new shares) and then sell your shares right after its ex-distribution date when its price has dropped by the amount of the distribution. Although you’ll owe tax on the long-term distribution (at a maximum of 15%), you will harvest a short-term loss that can be used to offset other short-term gains you’ve realized in your portfolio that would otherwise be taxed at a higher rate.

3. Simply continue to hold the fund as long as it is highly ranked. You will owe tax on the long-term capital gain distribution (at federal rate not exceeding 15%), but the shares will be worth 6.5% less than they otherwise would be worth when you ultimately sell the fund, reducing the amount of your capital gain at that time.

Note that this example assumes there is no change in market value of the fund.

Although distributions are taxable, they do not reduce the investment gain on a fund, they merely exchange some of your shares into cash.

There is no perfect answer to the question, “Should I hold on to a fund that is about to make a distribution?” We suggest that you consider the different variables, such as when you purchased the fund, at what price, etc. Ultimately we follow of the adage “Don’t let the tax tail wag the investment dog.”  Tax considerations are important, but following an investment discipline is even more important.

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