Q.: I just got a $7,000 dividend from a mutual fund that usually only pays small dividends and is now only worth about $62,000. At first, I thought that was great, but the fund has dropped in price (was close to $70,000 last month) and now I am wondering what happened. Can you shed some light on it?
–Tom in Akron
A.: Tom, I can try.
First, whenever a stock or a fund pays out a dividend, the value of the holding is adjusted down. Say you gave $1 to a co-worker, your net worth just dropped by $1. The same thing happens when a company pays a dividend. It takes cash and pays it to shareholders and its value drops by that same amount.
Here is how that works using a hypothetical example. There are three key dates: the record date, the ex-dividend date, and the pay date. The company declares it will pay a dividend of $1 to anyone holding its stock on March 31. That is the record date. The stock exchange then determines the ex-dividend date, typically the day before the record date. On the ex-dividend date, if the stock would have traded at $100 per share, the price becomes $99 to reflect the $1 in cash that will be paid to those that owned the stock on March 31. The pay date is the date the cash is disbursed.
You got a $7,000 distribution and the fund dropped $7,000 which aligns with the basic mechanism I just described. $7,000 is a lot and unusual so my suspicion is that it is not a standard dividend but a distribution of capital gains.
By law, mutual funds must pass net profits from its trades for the year back to its investors in the form of a distribution. It is common after a strong rise in markets that funds would have net gains from trading. It is also common that gains are often triggered in volatile years like 2020 when people flee the market forcing fund managers to sell stocks to meet redemptions.
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These capital gain distributions create no tax issues in IRAs, Roth IRAs or tax deferred retirement plans, but if these distributions occur in taxable accounts, you will report the $7,000 on Schedule D and pay the applicable taxes. The distribution will be coded as short or long term based on how long the fund held the securities. You pay ordinary rates on short term gains and long term capital gain rates on long term gains.
This is the time of year that these distributions are typically made. Most fund families have published the record dates, ex-dividend dates, pay dates and estimates of the amounts of capital gain distributions. If you have large holdings in a taxable account, or intend to buy a fund soon, it is a good practice to review these potential payouts so there are no surprises when you file your tax return.
For many people, having capital gains thrust upon them when they did not proactively sell a holding is bothersome and, in some cases, costly. That extra gain can push Adjusted Gross Income or Modified Adjusted Gross Income up triggering additional taxes or costs.
If that would be the case for you, you are not powerless. It may be possible to construct your taxable holdings in more tax efficient ways. Funds that don’t trade as often are said to have lower “turnover” and tend to have lower gain distributions. Plain-vanilla index funds are good examples of this. Some fund management teams are very sensitive to these distributions and actively manage the tax accounting when they trade. These often use the moniker “tax-managed.” You can also use exchange-traded funds which barring something funky like leverage are more tax efficient by virtue of their structure.
If you have a question for Dan, please email him with ‘MarketWatch Q&A’ on the subject line.
Dan Moisand is a financial planner at Moisand Fitzgerald Tamayo serving clients nationwide from offices in Orlando, Melbourne, and Tampa Florida. His comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some questions are edited for brevity.
Source: finance.yahoo.com