This information is not intended to be individual advice. We recommend that you consult with your accountant before implementing any of the strategies we discuss here.
If you want to invest in mutual funds without getting surprised by a big tax bill, you need to understand how mutual fund distributions work.
I presented a webinar on mutual fund distributions recently. Click here to watch Mutual Fund Distributions, Reporting, and Taxes.
Before we get to distributions, let’s cover the basics.
What is a mutual fund?
A mutual fund is a special kind of company that buys and holds investments on behalf of shareholders. Mutual funds own shares in other companies and are also divided into shares themselves. If you own 10 percent of the shares of a mutual fund, you get 10 percent of the fund’s earnings.
Investors often want to know the price per share, or net asset value (NAV), of a mutual fund. We calculate it by dividing the total value of the fund’s assets by the number of shares it’s divided into. For example, if a fund is worth a total of $60,000 and is split into 1,000 shares, its NAV is $60.
Mutual funds have two essential functions:
- Owning investments (stocks or bonds): The mutual fund’s manager invests the fund’s assets, hoping to make a good return for the mutual fund’s shareholders. Most mutual funds own hundreds, or even thousands of stocks or bonds (if it is a bond mutual fund).
- Collecting dividends: Because a mutual fund owns stock in companies, it gets a portion of those companies’ earnings as dividends. A mutual fund might collect thousands of dividends throughout the year.
What are mutual fund distributions?
Under the Investment Company Act of 1940, which created the legal structure for mutual funds, mutual funds must pass at least 98 percent of their income to their shareholders every year. Mutual funds don’t pay taxes directly on their income. Instead, the IRS collects tax on that income from the fund’s shareholders.
At the end of the year, the mutual fund adds up its dividends, and realized gains and losses. Then it distributes to each shareholder their proportional share of total dividends plus any net realized gains. The distribution reduces the fund’s cash, decreasing its NAV. The decrease is equal to the amount distributed, so shareholders still have the same amount of value after receiving a distribution. They just have some of it as cash instead of as shares of the mutual fund.
Does that matter? It depends on whether the distribution goes to a taxable account.
Holding mutual funds in tax-deferred vs. taxable accounts
Taxes are deferred on retirement accounts like 401(k)s and IRAs. The government taxes all withdrawals from those accounts in the same way. Receiving a distribution from a mutual fund in a tax-deferred account and reinvesting the distribution in shares of the fund will not have any impact on the after-tax return from the investment.
If you get that distribution in a taxable brokerage account, however, you’ll have to pay tax on it that year. The government taxes some distributions, like bond interest, at ordinary income tax rates, and others (qualified distributions) at capital gains tax rates.
Many investors choose to reinvest their dividends. With reinvesting, the mutual fund uses your dividends to sell you more shares of itself instead of sending you a distribution check. If you don’t remember setting your mutual fund investment up that way, this can be confusing! You don’t receive any cash, but you still have to pay tax on that dividend. At Sensible Financial, we usually choose not to reinvest dividends. We use the cash that comes in to rebalance the account. Instead of buying more shares of the mutual fund the distribution came from, we use the distribution to invest in whatever asset class our client needs to purchase to get back “in balance”.
Now that you understand mutual fund distributions, let’s talk about what you can do with this knowledge to become a better investor.
What are the two types of mutual funds?
Actively managed funds have:
- Managers who buy and sell stocks based on their knowledge and predictions about the market
- More transactions and more transaction costs
- Higher realized capital gains potentially resulting in higher taxes for shareholders
Passively managed funds have:
- Fund managers who buy and sell less often
- Fewer transactions and fewer transaction costs (managers trade stocks only to maintain a certain proportion of each company they hold)
- Lower realized capital gains, potentially resulting in lower taxes for shareholders
An index fund is a good example of a passively managed fund.
As an example, the five largest actively managed mutual funds have turnover ratios between 27 and 30 percent, while the five largest index funds have turnover ratios between 2 and 8 percent. Some actively managed funds have turnover ratios above 50 percent! Funds with lower turnover ratios are generally realizing and distributing fewer gains, which means lower near-term taxes for the investor.
To be more tax-efficient, know your tax cost ratios
To quantify that tax burden, Morningstar calculates a metric called the tax cost ratio. It measures how much investors’ distribution taxes reduce a mutual fund’s annualized return. The five largest actively managed funds have tax cost ratios between 1.40 and 1.79 percent, whereas the five largest index funds have ratios between 0.14 and 0.60 percent. The index funds are more tax efficient.
Sensible uses a lot of passively managed funds because we want you to keep more of your returns. Plus, actively managed funds usually have higher fees and often return less than index funds on average.
Exchange traded funds
If you value tax efficiency, consider investing in exchange traded funds (ETFs). Most ETFs are index funds, though some are actively managed. The way investors buy and sell shares of ETFs means the ETF doesn’t need to do as much trading, which means fewer gains to distribute. Plus, there’s a loophole in the tax code (beyond the scope of this article) which lets the ETF’s sponsors eliminate most of the capital gains.
The details are complicated, but the bottom line is that ETFs rarely need to distribute capital gains. Because ETFs are so tax-efficient, Sensible often chooses them for clients.
Using mutual fund distribution estimates
In late November every year, mutual funds publish estimates of their distributions for that year. Financial advisors like Sensible use that information to advise our clients.
Say you own shares of a mutual fund. You realized losses this year of $9,400 because the market was down and because you sold some shares during the summer to buy a new car. In November, your mutual fund sends you an estimate saying you can expect $3,500 in long-term capital gains distributions from them this year. So, your long-term capital losses this year will be $5,900.
Because you got this information in November, you have a little time to do something about it. You can:
- Do nothing. You’ll finish the year with $5,900 in capital losses. You can take up to $3,000 this year as a tax deduction against your ordinary income (e.g., salary and dividends) and use the remaining $2,900 as a deduction next year.
- Sell another investment. This is a good option if you have an investment you want to get rid of but have hesitated to sell because of the capital gain. If the gain you get from selling the investment happens in the same year as the loss, the two can offset each other, leaving you with zero capital gain at the end of the year.
Investing before the ex-dividend date
Another factor you should know about when investing in mutual funds is ex-dividend dates. The ex-dividend date of a fund is the day on which the fund will issue shareholders a distribution.
Say you buy a mutual fund a day before the ex-dividend date. The next day, the fund’s NAV will decrease and it will send you a taxable dividend equal to the amount of the decline in the NAV. Sounds like you should wait to buy, right?
Not necessarily. Waiting more than a few days to buy a mutual fund could be risky because the stock market is unpredictable and can change drastically in a short period of time. One might miss a large uptick in the market waiting for that dividend to be paid out. At Sensible, if a client has the cash to invest, we buy shares in the mutual fund – even if a distribution is coming up soon. It helps that we usually choose tax-efficient index funds and ETFs.
Now that you know about mutual fund distributions and their tax implications, you’ll be in a better position to decide which investments you should put in which accounts.
Sensible prefers to put equity (stock) mutual funds in taxable accounts. Stocks tend to have higher increases in value and capital gains over time. In a taxable account, they can benefit from the capital gains tax rate. We prefer to put fixed-income investments like bonds in tax-deferred accounts like an IRAs or 401(k)s because the capital gain rate is not available in those types of accounts.
Investing wisely in mutual funds
Mutual fund distributions are a natural consequence of the tax code that created them. Investors holding mutual funds in retirement accounts can be indifferent to distributions, and choose to reinvest them without worrying about tax consequences. In non-retirement accounts, those distributions create a tax obligation. There are a few things you can do to minimize that obligation.
- Choose passively managed funds like index funds and ETFs
- Use mutual funds’ distribution estimates to inform buying/selling decisions at the end of the year
- Consider, but be wary of, delaying investing in advance of a planned distribution
- Locate equity investments in non-retirement accounts
I hope this article helped you better understand mutual fund distributions! If you still have questions or want specific advice for your unique financial situation, contact one of our advisors. We’re happy to help.