Using Distributions to Lower Your Tax Bill

December 12, 2013

cutting-costsIn our last post, we explained that at times it may be beneficial to sell a fund after its distribution. Because a fund’s NAV drops by the amount of its distribution, you’d be selling the fund at a lower price, and you may be able to realize a smaller gain or even a capital loss that you can use to offset other gains. The amount of a fund’s distribution is added to your cost basis when you reinvest it in new shares and this also may help you realize a loss that can be used to offset other gains.

Let’s look at an example: say you invested $10,000 in Ariel Appreciation (CAAPX) on August 2, 2013 and you learned in early November that the fund was planning to make a large distribution – $2.51 long-term capital gains and 1.13% short-term capital gains on November 14.

If you sold the fund on November 13 in order to avoid the distribution, you’d realize $594 in short-term capital gains. Short-term capital gains are taxed at your income tax rate. Assuming the maximum 39.6% rate, you’d owe $235.22 in taxes.

But if you waited a just few days and sold your shares on November 15, the day after the distribution, you’d end up paying just $133.89 in taxes.

Here’s how it would work:

1. Purchase $10,000 of CAAPX on 8/2/2013 @ $53.58/share

2. Receive distribution on 11/14/2013

    $2.51/share = $468.46 (long-term cap gain)
+ $1.13/share = $210.90 (short-term cap gain)
                              $679.36 total distribution

3. Reinvest distribution in new shares 11/14/2013. Your new cost basis is $10,679.36 (initial $10,000 plus $679.36 distribution)

4. Sell Shares 11/15/2013 @ $53.31/shares = $10,629.11 proceeds

Realized Loss

     $10,629.11 (proceeds)
–  $10,679.36 (cost basis)
=  $50.25  short-term loss

5. Use realized loss to offset the short-term capital gain distribution.

    $210.90 short-term gain from the distribution
–   $  50.25 short-term loss realized from selling the shares
=   $160.65 net taxable short term gain

6. Reassess your tax liability.

      $160.65 short-term gain (taxed @ 39.6% max. tax rate)    =  $  63.62
+   $468.46 long-term gain (taxed @ 15% max. rate)                 =  $  70.27
=                                                                  Total Tax Owed       =  $133.89

 Keep in mind that you should not buy back the fund you just sold at a loss within 30 days of the sale. That would violate the “wash sale” rule and you would not be able to claim the tax loss.

It’s also important to remember not to let your investment strategy be ruled by your tax strategy.  In other words, you should not sell a strong performing fund that is highly ranked just to work a little tax jujitsu.

If you decide to execute a tax sale like the one described here, be sure you have a good, highly-ranked fund lined up to invest with the proceeds, and be sure that fund is not about to make its own taxable distributions or you may walk into another tax liability.


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