With the year-end upon us, many investors see it as the time to rebalance their investment portfolios. However, savvy investors need to be aware of just when the timing is “right” or “wrong” to make that buy or sell trade happen.
Mutual funds are required by law to distribute the income earned within the fund each year to the shareholders of the mutual funds in the form of dividends and capital gain distributions. Typically, the bulk of these distributions occur near year end, late in the month of December. The dividends and interest earned within the mutual fund as well as capital gains from sales must be distributed to the shareholders. At the time of the distribution, the net asset value (NAV) of the fund decreases by the amount of the per share distribution because those assets are no longer held within the fund. The result is taxable income to the shareholder and a reduction in the NAV of the mutual fund.
Thus, the date to be aware of is the ex-dividend date – the first day that buyers of the mutual fund will not receive the dividend being paid out by a mutual fund.
Buyers will want to wait until after the ex-dividend date to buy into a mutual fund. After that date they are buying into the fund at a lower NAV, because of the dividend distribution. If they buy the mutual fund prior to the ex-dividend date, they are buying the fund at the higher NAV, receiving a taxable distribution, and then being left with the mutual fund at the lower NAV. The major dilemma of purchasing before the ex-dividend date is that although the buyer will receive income in the form of a dividend and/or capital gain distribution, he will also have to report the income on his tax return and pay taxes on that distribution. After having been hit with a tax bill on the distribution, the buyer would be left with less money in his wallet than if the mutual fund was simply purchased without the dividend payment.
The opposite is true for sellers. Sellers want to sell their mutual fund shares before the year-end distribution. Selling before the ex-dividend date end will result in the entire gain being subject to lower capital gain tax rates. Waiting until after the ex-dividend date, the seller will receive a taxable distribution. This scenario would result in income from the sale of the mutual fund being taxed at a capital gain, but the dividend distribution portion being taxed at a higher ordinary income tax rate.
Bottom line is as follows – buyers want to purchase shares after the ex-dividend date while sellers should sell shares before the ex-dividend date. Following these rules should help investors to lessen their tax exposure on their mutual fund income.