A note on fund distributions and how they impact your statement and your taxes.
It is that time of year again when most mutual funds distribute their annual dividends and capital gains. While this yearly ritual does not draw much attention, it can have a significant impact on your taxes over time and can make reading a gain/loss report slightly confusing for the uninitiated. I would like to give a brief summary of these distributions and their impact on your accounts.
Why Mutual Funds are Impacted
Mutual funds are registered investment companies regulated by the Investment Company Act of 1940. An investment company is defined as “an issuer that is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire 'investment securities' having a value exceeding 40% of the value of its total assets (exclusive of government securities and cash items) on an unconsolidated basis.” This definition includes mutual funds, closed-end investment companies, face amount certificates, and most exchange traded funds. As proof of the inflation in words required by Congress to get things done since 1940, the entire Act is 114 pages, and it is just as boring as one would expect.
In order to avoid taxes at the fund company level, an investment company must distribute all income each year to shareholders. There are four classifications of distributions that are reported to you on form 1099-DIV. These distributions include dividends, short-term capital gains, long-term capital gains, and non-taxable distributions. If you own these funds in an IRA or a Roth IRA, there is no tax consequence of the distribution. If you own these funds in a non-IRA account, they must be reported on your tax return each year.
Each distribution is declared toward the end of the year and usually pays out in December. The distribution does not depend on when you purchased the fund, and it is possible to own a fund at a loss and still receive a taxable distribution for the year. We try to limit the impact of this possibility by checking our funds at year end for losses and selling funds with large distributions before the record date if there is a meaningful loss in the fund.
The Impact to Your Statement
The way these fund distributions impact your statement are important to note. In most cases we reinvest all distributions back into the fund. On the date of the distribution the fund price drops by the amount of the distribution because the assets are paid out to shareholders. This caveat may cause the fund to show a very large drop on the date of the distribution that is counterbalanced by the fact that the amount of the drop is reinvested on the same day. For instance, if you own 100 shares of a mutual fund at $20 per share that pays a $5 distribution, the day of the distribution your fund will show a 25% loss, but the next day you will still have $2,000 in the account but will own 133.33 shares at $15 instead of 100 shares at $20. Importantly, your basis will be increased by the amount of the distribution. So, if your tax basis in the above example was $2,000 before the distribution, since you paid taxes on the reinvestment amount your tax basis after the distribution will increase to $2,500 and your position will show a $500 loss. This is true in both IRA accounts and non-IRA accounts because the same tracking format is used regardless of tax qualification.
This situation can cause a great deal of confusion when looking at a gain/loss report. It may appear that your funds have declined in value due to reinvestment of distributions. In funds that you have held for many years your basis will increase over time as the fund distributes annual income. It is always important to look at how much your initial investment was and add any subsequent purchases to the total instead of reading the gain/loss report. While this is inconvenient, it ensures that your fund will be reported correctly to the IRS when you eventually sell shares. It would be a great disadvantage to pay taxes on distributions and then pay capital gains again when a sale is made. We track performance separately and it is much more instructive to look at a performance report than a gain/loss report. This is true for all securities that we hold, not just mutual funds. The same mechanism applies when we reinvest dividends in individual stocks. If you ever have any questions about your returns, your advisor will be happy to help you determine the real performance of your holdings over time.
While it is never fun to generate taxable income, taxes are one of Ben Franklin’s two certainties (death being the other) and in some cases, paying the taxes over time does make rebalancing easier, and prevents most funds from building up unmanageable gains that force us to hold things that we would prefer to sell. Most of our funds are relatively tax efficient because they have low turnover as one of our selection criteria. In addition, most of our funds are growing in size from new investor contributions and can use new assets to rebalance the portfolio instead of selling securities to reach a target allocation.
We owned one fund that required us to take proactive action this year. The fund was negative for the year but due to embedded capital gains and sales made throughout the year a 10% capital gains distribution was made in December. In appropriate accounts, we sold the fund prior to the distribution to harvest the loss and avoid the capital gains and we will re-purchase the fund in 31 days. If you were one of the clients who had a non-qualified position in this fund at a loss (or up to a 5% gain) the income or loss will be reported to you on form 1099-B and will impact your tax bill come April. This is a normal part of investing and the benefits we get from active management should outweigh negatives compared to purchasing passive funds or ETFs, which have a tendency to have lower annual distributions. Keep in mind that you still have to pay the taxes when you sell a more tax efficient fund, so it is the timing that is changed, not necessarily the tax bill. In addition, if we sell a passive fund with a very large, deferred gain, we may end up in a higher capital gains bracket than if we pay the taxes a little each year.
This income will be reported to you on form 1099-DIV if held in a non-IRA account and will increase your tax bill come April. This is a normal part of investing and the benefits we get from active management should outweigh negatives compared to purchasing passive funds or ETFs, which have a tendency to have lower annual distributions. Keep in mind that you still have to pay the taxes when you sell a more tax efficient fund, so it is the timing that is changed, not necessarily the tax bill. In addition, if we sell a passive fund with a very large, deferred gain, we may end up in a higher capital gains bracket than if we pay the taxes a little each year.
While we do make an effort to minimize the tax impact of annual distributions, the reporting confusion on your gain/loss report is unavoidable as custodians are required to report your monthly and annual statements in this manner. You may hold a fund for many years that doesn’t seem to have any gains, when in fact your holding is significantly more than your initial investment, but distributions have cause basis to increase each year. We believe that utilizing actively managed funds with very low turnover is in your best interest despite the tax and reporting inconveniences. While ETFs may be more efficient on a tax basis, they are typically over-diversified and may have counter party risks that do not exist in mutual funds, often negating any potential tax efficiency benefit. If your annual distributions create an exorbitant tax consequence, we can use asset location strategies to mitigate the annual impact of distributions; we can also use more individual stocks in your non-qualified accounts to limit distributions, if necessary.
As always, please contact your advisor with questions you may have. Thank you for your continued trust in Basepoint Wealth as we help you define and reach your financial goals.
W. Allen Wallace, CFA
Chief Investment Officer
Basepoint Wealth, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.