Federal Employees News Digest

Employees Who Invest in Mutual Funds Should Avoid “Buying a Dividend” At This Time of Year

Employees who invest in stock mutual funds held in taxable (non-retirement) accounts should avoid an investment move called “buying a dividend”. This column discusses the potentially painful tax consequences of “buying a dividend”. The tax consequences of “buying a dividend” can be particularly shocking to investors who invest in stock mutual funds in December at which time many of these fund companies distribute to their fund shareholders the majority of their annual dividends and capital gains.

“Buying a dividend” involves investing in a stock mutual fund shortly before the fund pays out its dividends and capital gains. This seems contrary to what an investor wants to do; namely, investing in a fund and then immediately receiving fund income in the form of a dividend and a capital gain generated within the fund. But as explained shortly, when investing in a mutual fund held in a taxable account (does not apply to retirement accounts such as the TSP or IRAs) or further investing in such an account just before the fund makes a distribution can result in the investor paying taxes on an investment that has decreased in value. To understand why, it is important to explain the mechanics of mutual fund distributions. 

Mutual funds must distribute at least 80 to 90% of their income in the form of dividends and/or capital gains to fund shareholders. A fund shareholder can elect to receive the dividends and capital gains either in the form of cash or purchase additional shares of the fund. With stock mutual funds, funds collect income from their holdings and retain this income within the funds until they pay it out to shareholders. The funds’ accumulated earnings prior to its distribution and payout to shareholders is reflected in the fund’s net asset value (NAV).

For example, a fund with 10,000 outstanding shares and currently worth $100,000 collects $5,000 in dividend income. The NAV before the dividend in $100,000/10,000, or $10.00 per share. When the fund collects the $5,000, the NAV or share price increases to $5,000/10,000 shares ($0.05 per share) resulting in a NAV of $10.05. When the fund distributes the $5,000 dividend income onto its fund shareholders, the money comes out of the fund and the NAV decreases to reflect the payout. The NAV decreases from $10.05 to $10.00 when the fund shareholders receive a distribution dividend of $0.05 per share and they will pay income tax on the dividend distribution. In short, while fund shareholders receive dividend income, the total value of the account is the same on the day after the dividend was distributed as it was the day before the dividend was distributed. Put in another way, an investor who buys shares of the fund on the day before dividends are distributed will pay tax on an investment that has decreased in value. The same is true for fund capital gain distributions.

In short, stock mutual fund investors who invest in a fund immediately before a fund distribution do not “make” money on the day of the dividend and/or capital gain distribution. That is why any effort to invest in a fund right just before a distribution to “capture” a dividend or capital gain does not make financial sense. 

Mutual fund investors of non-retirement accounts (not retirement accounts such as TSP and IRAs) are advised about the tax consequences of fund dividend and capital gain distributions. Short-term capital gains are taxed at ordinary tax rates, while qualified dividends and long-term capital gains are taxed at preferential capital gains tax rates. 

What should mutual fund investors in non-retirement accounts take away from this discussion? The discussion certainly does not imply that the possible adverse tax consequences should prevent someone from investing in a stock mutual fund. Dividends and capital gains should be thought of as money that the fund makes throughout the year. In fact, mutual fund shareholders who invest regularly throughout the year (called “dollar cost averaging) are investing most efficiently. But for investors who decide to invest late in the calendar year in December at which many time stock mutual funds distribute their dividends and capital gains, there is no reason to invest in the fund right immediately before the distribution. If an investor does, then in reality the investor is paying unnecessary taxes on money the investor has not “made”. Investors should therefore be aware of the timing of upcoming distributions when making an initial investment or investing additionally into a fund they already own.

Mutual funds usually announce in late November on what dates in December they plan to make distributions of dividends and/or capital gains from their funds. Employees who plan to invest in a mutual fund in December should therefore check with the fund and ask when these distribution dates will occur and invest immediately after these dates. Furthermore, since the issue of “buying a dividend” is not an issue specific to the last month of the calendar year, an individual making a potential investment in a mutual fund should always check the fund’s payout history to make sure the fund is not about to pay a dividend and/or capital gain distribution in order to avoid “buying a dividend”. 

Edward A. Zurndorfer is a Certified Financial Planner, Chartered Life Underwriter, Chartered Financial Consultant and IRS Enrolled Agent in Silver Spring, MD.  Tax planning, Federal employee benefits, retirement and insurance consulting services offered through EZ Accounting and Financial Services, located at 833 Bromley Street Suite A, Silver Spring, MD 20902-3019 and telephone number 301-681-1652.  

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Contributors

Edward A. Zurndorfer Certified Financial Planner
Mike Causey Columnist
Tom Fox VP for Leadership and Innovation, Partnership for Public Service
Mathew B. Tully Legal Analyst

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