5 Things Every Investor Needs to Know about Year-end Distributions

December 7, 2016


Year-end mutual fund distributions can be a common source of confusion for fund investors, but learning some of the basics can really pay off.

It can help you avoid buying into an unexpected tax liability, and it can also help you better understand your fund’s performance since distributions can make it seem like your fund lost money when it really hasn’t.

Here are five things every fund investor should know about year-end distributions:

1. Distributions can add to your tax bill

If you invest in a tax-deferred account like an IRA or 401(k) then you don’t need to worry about the tax implications of distributions. But if you hold funds in a taxable account, distributions are taxable to you, whether you take them in cash or–as most people do–have them reinvested in new shares.

You’ll want to trade carefully to avoid unwittingly buying into a taxable distribution. If you buy a fund right before it pays out, you’ll be buying a tax liability before you’ve even participated in the fund’s performance.

Check to see if a fund is expected to make a distribution before you buy it. Most funds publish estimated distribution information on their websites. Members of NoLoad FundX newsletter will find estimated distribution information for hundreds of stock funds in the December issue. You also might consider focusing on ETFs this time of year.

2. Distributions don’t affect fund performance, but they may appear to

Fund performance includes distributions. When a fund distributes capital gains or income, its share price drops by the amount of the distribution. Although a fund’s NAV is lower on the day it makes a distribution (the “ex-date”), investors own more shares at the end of the day, or they have additional cash in their account, which makes up for the difference in share price. If the price of your fund suddenly drops one day in November or December, don’t panic; check to see if it made a distribution.

Returns in NoLoad FundX are all adjusted for all distributions, but if you look at a reporting service like Yahoo Finance, a fund’s dividends may be missing. This can make it look like your fund lost money when it really hasn’t. This is particularly vexing with bond funds, whose dividends often represent most or all of a fund’s gain over time. If a reporting service omits those dividends, the returns you see on their charts can be way off. For accurate performance data, it’s better to rely on the fund’s website.

3. Capital gain distributions are based on how long a fund held a security, not on how long you’ve held the fund

“How can I get a long-term capital gains distribution when I’ve only owned the fund for a few months?,” an investor asked us recently. The answer is that the tax status of a fund’s capital gain distribution is determined by how long the fund held an underlying security, not how long you owned the fund. The gain is considered long-term if the fund held a security longer than one year; otherwise it is considered short-term.

This is why you can receive a long-term capital gain distribution from a fund that you’ve only held for a few months or a short-term capital gain distribution from a fund that you’ve held for many years.

4. A fund can have losses and still distribute gains

A distribution indicates that some of the securities in a fund’s portfolio were sold at a profit or that some of the securities the fund owned paid dividends. It does not indicate whether the fund has a positive or negative return for the year.

For example, if a fund sells a stock it’s held for the past three years and realizes a big gain, it must pass that gain onto shareholders, whether the fund itself is up or down during this particular calendar year. So, a fund can still distribute taxable gains even if recent performance is negative.

5. Stock funds & bond funds distribute in different ways

When a stock mutual fund makes a year-end distribution of capital gains and income, the fund’s share price drops by the amount of the distribution. But many bond funds distribute income to shareholders on a monthly or quarterly basis, and in this case, the bond fund’s share price does not drop by the amount of the income distribution.

With bond funds, the internal accounting is different: Dividends accrue daily, and are then paid out to shareholders every month or quarter. Bond funds collect the income from the underlying bonds and keep it in a separate internal “bucket.” A bond fund calculates a daily accrual rate for the shares outstanding, and shareholders only earn income for the days they actually hold the fund.

For example, if you buy a bond fund two days before the fund’s month-end distribution, you would only receive two days’ worth of income that month. On the other hand, if you sell a fund part-way through the month, you will still receive a partial distribution at the end of the month, prorated for the days you actually held the fund.

But there are exceptions. Not all bond funds distribute income monthly or quarterly. Some funds distribute income on an annual basis. In this case, the fund incorporates the income from the underlying bonds into the fund’s NAV, like a stock fund, and distributes it once a year to shareholders.

This article originally appeared on Forbes


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