At this time of year, you need to be aware of the ex-dividend date of any mutual funds you plan on purchasing. If you heed this advice, you avoid some nasty tax and investment performance consequences.
To explain why, let me first define ex-dividend date. On the ex-dividend date, all registered owners of a mutual fund become eligible to receive any declared dividends and capital gains distributions. If you do not own the fund by that date, you do not receive the payout. You also want to keep in mind the distribution date. After that date, you can go ahead and buy your shares without the negative impact on the NAV (Net Asset Value).
At this time of year (Oct Dec), most mutual funds declare their dividend and capital gains distributions. You have nothing to worry about if you want to buy stock. Such distributions do not impact the share price. However, if you own mutual funds you need to consider the impact of this distribution on the NAV or share value. On the day of the distribution, you will see the NAV of your mutual fund shares drop by the declared dollar amount. In industry parlance, we call this buying dividends.
Heres how it works. Throughout the year, the cash from dividends paid by stocks within the fund and capital gains realized from the sale of assets either accumulates adding to the funds cash balance or gets reinvested in equities by the fund manager. At the end of the year, the fund must distribute at least 95% (?) of the dividends/realized capital gains not reinvested in new securities. Typically, funds declare this distribution in the months of October and November.
At the end of the year, the NAV of the fund reflects the value of all the investments it contains plus the starting cash balance and the accumulated cash resulting from dividends and capital gains. When the fund manger distributes the dividends and capital gains, the NAV drops a corresponding amount. Thats fine for the people who have owned the fund most of the year. They enjoyed the NAV appreciation that resulted from the growth of the investment, the dividends, and the realized capital gains. An investor who buys just before the ex-dividend and distribution dates has purchased cash value. When the fund distributes the cash, the new shareholder sees the value of her fund shared decrease, receives back part of her investment, and then gets to pay taxes on in essence her own money! Not a good deal.
A look at an example will show why you want to avoid buying dividends. Suppose the ex-dividend date is tomorrow and you buy shares at a NAV of $25. The fund declares a dividend of $3.00 per share. Doing so means that tomorrow the fund distributes $3.00 of the NAV so your shares are now worth $22 instead of the original $25. You now owe taxes on $3.00 per share even though you didnt enjoy the price appreciation you would have had if you had purchased at the beginning of the year.
You can see that you lose in this situation. You should avoid buying dividends. Instead, wait until after the after the distribution date to purchase your shares. Then you will get to enjoy any price appreciate throughout the year and not pay taxes on the return of your own cash!
About the Author:
Catie Fitzgerald is a 10+ years veteran of the money management profession and the founder of Financially Savvy. Financially Savvy provides investors with the education and resources necessary to gain confidence in making their own financial decisions. We offer a variety of educational venues including classroom sessions, one-on-one coaching, and online resources. If you have a personal finance question you would like answered, contact Catie at cfitz@financiallysavvy.com.