Year-End Distributions: 3 Actions To Take

December 10, 2013

tax-papersIf you are like many investors, year-end mutual fund distributions of capital gains and income can cause you to wonder if you should stay with a fund and receive its taxable distribution or sell the fund to avoid receiving the distribution.

Paying taxes on your investment gains is just part of investing, but you don’t want to needlessly incur taxes you might otherwise have avoided.

But what action should you take, if a fund you own in a taxable account is making a distribution? You have three options:

(1) You could hold on to your shares, but you will be handed a tax liability.

(2) You could hold the fund, receive the fund’s distribution and then sell your shares once the fund’s NAV has dropped by the amount of the distribution.  This may seem counterintuitive, but this can sometimes be a useful tactic.

(3) You could sell your shares to avoid the distribution, but you might realize a taxable gain that could be greater than the distribution.

Each of these three options has its merits. Your decision should depend on the amount of the fund’s distribution; how much of the distribution is allocated to long-term gains, short-term gains and income; and the amount of the gain or loss you’d realize if you sold your shares.

Below, we walk through these three options, using Ariel Appreciation (CAAPX) as an example.

CAAPX made a distribution of $3.64 on November 14, 2013. The distribution was primarily long-term capital gain ($2.51, or 10.7% of the fund’s NAV). Long-term gains are better than short term gains because they are taxed at a lower rate –a maximum of 15% (assuming you make less than $400,000 a year). The remaining $1.13 (4.8% of the NAV) was short-term capital gain, taxed at your ordinary income tax rate (maximum 39.6%).

Option #1  Hold the Fund & Receive the Distribution

If you haven’t held a fund longer than 12 months and have a significant gain, you are probably better off holding the fund and receiving the distribution, especially if the fund is distributing long-term capital gains or if the total distribution is small (less than 1%) of the fund’s NAV (or share price).

If you bought Ariel Appreciation (CAAPX) in March 2013, as we did in the Monthly Upgrader Portfolio, your position would have been up 22% through October 31, 2013, so if you sold it to avoid the fund’s distribution, you’d realize a sizeable short-term gain.  But if you continued to hold the fund, you’d get a distribution of mostly long-term gains, which are taxed at a lower rate than the short-term gains you would have realized by the sale.

Option #2  Hold the Fund, Receive the Distribution & Sell the Fund After the Distribution

A fund’s NAV drops by the amount of its distribution, and, when you reinvest the distribution in new shares, the amount of the distribution becomes part of your cost basis.  So it may be beneficial to sell a fund after its distribution.  By selling the fund at a lower price, you also may be able to realize a capital loss that you can use to offset other gains.

If you bought CAAPX in early August you’d have had a 4.8% gain at the end of October. You could have opted to receive CAAPX’s distribution of primarily long-term capital gains and then sell the fund after its distribution, realizing a small short-term loss.  By doing so, you could have effectively turned a short-term gain into a long-term gain.  (We’ll share a detailed explanation of this in our next post).

Option #3  Sell the Fund to Avoid the Distribution

The only time it pays to sell a fund prior to the distribution is if you have a long-term capital gain that is similar in size to the distribution, which will include both short-term capital gains and income. Otherwise, you’re better off selling after the distribution, if at all.

We don’t necessarily recommend you sell a highly-ranked fund you would otherwise hold just for the sake of a tax strategy.

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