‘Tis the season when investors find out whether their mutual fund has been naughty or nice this year.
Yes, it’s that time again when mutual funds are required to distribute to shareholders any profits realized from trading, net of any losses. In turn, shareholders are obligated to pay taxes on this income.
When a distribution is paid, a fund’s share price declines by the amount of the distribution. Should a fund trading at $20 per share, for example, make a 5% long-term capital gain distribution of $1, a fund investor would have one share worth $19 and $1 in cash.
The combined value of the $19 share and $1 cash equals the pre-distribution amount invested; however, shareholders owning the fund outside of a retirement account will owe tax on the $1 distribution. This is true even if the shareholder made no fund sales themselves during the year.
The tax rate applied to this distribution can either be the friendlier capital gain rates (max of 20% plus 3.8% Medicare surtax) or higher ordinary income rates (43.4% top Federal rate) depending on whether the gains distributed were a result of selling stocks held for less than, or longer than, twelve months.
To minimize the impact of capital gain distributions, Vista favors tax-friendly index- and exchange-traded funds from Vanguard and broad-based asset class funds from Dimensional Fund Advisors (DFA). These funds trade their holdings much less frequently compared to typical actively managed funds, whose managers tend to dart in and out of stocks at a frenetic pace.
Not all of our funds are immune to sizeable distributions, however. Small- and micro-cap funds, for example, often produce larger distributions (3% to 5% this year) because of their more targeted holdings. When those stocks perform well and grow, as they’ve done this year, funds must sell them to maintain style purity. Consistent exposure is a good thing, and also one of the reasons we seek to hold these funds in clients’ retirement accounts whenever possible.
Regardless of their size, December capital gain distributions can catch those who keep a close eye on their stockings by surprise. Remember, these distributions will knock an equal amount off a fund’s daily closing share price. And since the cash distribution is not received into an investor’s account until the following day, it can temporarily appear as if the entire account has lost value.
So, if it seems your portfolio has been surprisingly naughty one day soon, it might just be a mutual fund distribution—Uncle Sam’s way of staying on everyone’s list.