Mutual funds generate income on their investment portfolios. The gain may be from dividends paid by the underlying stocks, interest from the underlying bonds, or net capital gains realized from turnover in the fund’s investments. Income dividends may be paid monthly, quarterly or annually. Capital gains are generally distributed in December.
Most mutual funds are pass-through entities; therefore, funds must pay substantially all net investment income and net capital gains to their investors, based on the number of shares they hold. You may receive the income distribution in cash or reinvest in additional shares of the fund. Regardless of what you do with those earnings, they are considered taxable, unless they represent interest from tax-free investments, such as, municipal bonds, or if the fund is held in a tax-deferred account.
Shareholders include the income on their individual income tax returns. The amount you received during the year should be reported on year-end statements and on Form 1099-DIV. Distributions should be classified as long-term and short-term capital gains, and qualified and ordinary dividends. Qualifying dividends are eligible for the favorable long-term capital gains tax rates. Short-term gains are passed through the fund in a similar manner and taxed at ordinary income rates.
If you are purchasing shares of a mutual fund, you should be aware of the timing when you buy shares toward the end of the year, with regard to dividend payments and capital gain distribution dates. All investors who own shares as of the close of business on the record date are entitled to receive distributions. It does not matter if you bought the shares one day or 10 years prior to the distribution. When you hold fund shares in a taxable account, you are taxed on the payout. Capital gains and dividend distributions generally reduce a fund’s net asset value (NAV) per share by the amount of the distribution on the ex-dividend date. This is usually the next business day after the record date. Distributions do not affect a mutual fund’s total return, but they do affect the after-tax return for shares held in taxable accounts.
Let’s say you own mutual fund shares with a NAV of $20 prior to the distribution. If the fund were to pay a distribution of $2 per share, on the ex-dividend date, the NAV should drop by the amount of the dividend. However, market activity could also affect the fund’s NAV on the ex-dividend date, so the NAV may change more or less than the distribution amount. If you were to purchase shares of the fund prior to the record date, you could be paying taxes on income you didn’t really earn.
If you own mutual fund shares in a tax deferred account, distributions are not taxable. Taxable income is normally generated only when money is withdrawn. Keep in mind that if you don’t set distributions to reinvest, cash will accumulate in your account. This may or may not be appropriate for your situation, but during an up year like we’ve had in the stock market, you could have missed nearly 25% growth on that cash.
Of the mutual funds Henssler Financial has on our recommended list, about 36% regularly pay dividends on one of the last days of the year. In total, 55% of the funds we watch pay their annual dividend during December. Generally, you find the important dates on a mutual fund’s website. Some of the dates you want to pay attention to include the declaration date, the ex-dividend date, the record date and the payment date.
Declaration Date: This is the date on which a mutual fund’s Board of Directors announces its approval of dividend payments.
Ex-Dividend Date: The day when it is too late to buy shares of a mutual fund and receive the dividend. After the ex-dividend date the trade price of the fund, usually, drops by the amount of the expected dividend.
Record Date: The official day a fund uses to determine the shareholders who are entitled to receive a dividend or distribution.
Payment Date: This is the date dividends are paid or credited to shareholders’ accounts.
At Henssler Financial we believe you should Live Ready, and that means understanding how your investments may affect your tax situation. If you have questions regarding your investment strategy, the experts at Henssler Financial will be glad to help. You may call us at 770-429-9166 or email at firstname.lastname@example.org.