This appears to be a piece of conventional wisdom among financial advice columnists (for instance, here and a buncha other places):
My question is, uh, why, or at least, “how does that work?” It seems like if the funds pay out their dividends et cetera at the end of the year, buying in at the last minute would be awesome, since you’d get the returns without having your money tied up for the whole year.
I’m sure I’m missing something. What is it?
The point is that the way distributions of mutual funds work, you DON’T get the returns. That’s because the value of your position drops by the same amount as the distribution.
So that if, for example, you own $10000 worth of mutual fund ABCDX, and on a certain day they pay a distribution of $2000, on the next day the value of shares of ABCDX has dropped exactly enough so that you now own $8000, plus $2000 (which is often reinvested in the mutual fund, getting you back into the original $10000). And that $2000 is taxable.
ETA: The way you actually get that $2000 return is if you had that fund for a longer period. Then you got the $2000 return gradually, throughout the year, as the actual dividends from the underlying stocks in the fund were received. But you don’t get it on the day of the fund distribution.
Thanks. I won’t go so far as to say that makes sense, but I think I understand the mechanism.
More importantly… if you have not owned the stock/fund for at least 60 days when the dividend is paid, it is taxed as ordinary income (35% max). Qualified dividends are taxed at the capital gains rate (15% max).
Of course, this makes no difference if the stock is being purchased within an IRA or 401k.
If suranyi’s explanation didn’t make sense, just think about it like this: An item is worth $80, but you give the cashier $100. They give you $20 back.
The stock in the example was never worth more than $8,000. It’s the value of the $2,000 dividend acting like cash back or a rebate that makes people willing to hand over $10,000.
If I recall correctly, the dividend is actually the distribution of both any dividends that the fund has collected from the holdings, and also any capital gains that the fund may have realized by trading positions in the fund. When you are looking at a fund, one metric to look at is the turnover ratio, which describes the amount of trading the fund does over the year. A high turnover can result in lots of capital gains that must be distributed to shareholders, but doesn’t necessarily result in an actual overall gain for the year. I learned this the hard way on the first fund I owned – it lost value, but still had distributions I had to pay taxes on.
I now only hold mutual funds in my Roth IRA. Everything in my taxable account is in actual stocks and not funds
There is no easy way to jump in and buy for an immediate gain as suranyi pointed out how fund NAV pricing is impacted by distributions.
To expand on it, the fund’s NAV contains all of the dividends and capital gains up until the point of distribution. For instance, if you buy on the first day of the year, and the fund waits until the last day of the year to pay out the dividends/capital gains, you would not lose out by selling your shares the day before everyone else gets their dividend/capital gain.
The fund’s NAV at the time of your sale should contain all the dividends/capital gains everyone else is getting on the distribution day.
Yeah, and you then get taxed on the change as income. Would be pretty dumb.