Plan ahead before you buy some shares in a stock mutual fund near year end, when the fund is about to pay a dividend. It might be better to wait until after the fund goes "ex-dividend," that is, wait until after the record date of the dividend payout. Otherwise, you "buy a dividend" and are stuck with paying unnecessary taxes on some of your own capital, without any real increase in your investment. As lots of other investors have learned the expensive way, funds can have losses and still make big distributions.
This is the nasty trap: A fund's net asset value -- its price per share -- drops by the amount declared as distributions of capital gains (profits from sales of securities in its portfolio) and income (dividends paid by securities it holds and interest earned on bonds and similar holdings). These distributions of gains and income during the past year are paid only to those who owned shares before the ex-dividend date.
What's the result of making a share purchase just before the dividend date? The purchase causes some of your own money to come right back to you as a distribution that you neither expect nor want. You're then liable for taxes on it -- unless you've some offsetting capital losses. It matters not that you own the shares for only a few days, which means your shares didn't earn the profits. Nor does it matter that you take the distribution in the form of additional shares that are automatically reinvested, rather than paid out in cash, and that the actual payout won't be made until January of the following year.
An example: In mid-December, you pay $10,000 for 1,000 shares of XYZ fund, which sells for $10 a share. A day later, XYZ declares a capital gains and income distribution of $1 a share that's automatically reinvested. Your fund holding remains worth about $10,000, assuming no other market-related fluctua¬tions of the share price occur. The three-fold consequences of the payout are:
1. XYZ's separation of the value of capital gains and dividends to be paid from the rest of its assets causes the net asset value of the share to automatically drop from $10 to $9 per share.
2. You now have a total of just over 1,111 post-payout shares.
3. You also owe taxes on the distribution of $1,000.
Assume the entire distribution is from long-term capital gains, and you're taxed at a rate of 15 percent. That entitles the IRS to siphon off as much as $150 in taxes. You also need to consider applicable state income taxes. But what a difference a day can make, provided you simply wait and invest the $10,000 after XYZ goes ex-dividend. Your adroit procrastination then enables you to buy the same number of shares for $9 each without saddling yourself with a tax obligation for the dividend.
Already have money stashed in funds? You also can benefit from taking distributions into account when plotting end-of-year strategies.
Call the toll-free numbers or go to the Web sites of the fund companies for information about year-end payouts; find out when they're going to declare distributions and how much they expect to distribute. Some funds will give you an idea of the expected size of the distribution, perhaps by comparisons with year-before distributions. Companies tend to follow fairly regular schedules; past distributions should indicate when the next ones will be paid.
Situations where you get a break. You don't always have to concern yourself with the dividend date in certain situations. One is when you plan to purchase shares for a tax-deferred traditional IRA or other retirement arrangement, with no tax due until you begin withdrawals from that plan, or for a tax-exempt Roth IRA.
Another situation is when you make a gift of a relatively small investment for a child with little or no other income and the child is under the age of 19 or a full-time student under the age of 24. The dividend distribution doesn't create an unintended tax liability for such a child, as he or she is relieved of federal income taxes on investment earnings under a specified amount that's adjusted annually to reflect inflation -- for 2015, $1,050.
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Julian Block writes and practices law in Larchmont, N.Y. He is frequently quoted in the New York Times, the Wall Street Journal and the Washington Post, and has been cited as: "a leading tax professional" (New York Times); "an accomplished writer on taxes" (Wall Street Journal); and "an authority on tax planning" (Financial Planning Magazine).
His tax guides include "Tax Deductible Travel and Moving Expenses," "Tax Tips for Marriage and Divorce," "Easy Tax Guide for Writers, Photographers and Other Freelancers," and "Home Seller's Guide to Tax Savings." For information about his books, go to julianblocktaxexpert.com.
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