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Friday, December 15, 2006

Mutual fund year end distributions

For almost a year, I had been interested in opening a mutual fund account but due to unexpected expenditures, tight schedule etc, never actually got around to opening one. More recently, the year-end distributions held me back. However, now that year-end is here, many mutual funds have either already made the dividend and capital gains distributions, or will be making it sometime soon.

Dividends and capital gains distributions happen because mutual funds buy and sell shares through out the year. At the end of the year, they pass these dividends and profits to their shareholders in the form of dividend and capital gains distribution.

Getting dividends and capital gains would be a good thing ordinarily. The problem is that people who buy a mutual fund just before these distributions could end up paying more in taxes. Since short term capital gains (typically apply to any shares held less than 1 year) are taxed at a higher rate than the long term capital gains (typically, the long term capital gains are 15% versus 28% or higher for the short term capital gains), people who buy the mutual funds just before the capital gains distribution, end up paying higher taxes on those shares since they have held it for less a year.

Paying taxes on profits would not be a bad thing except that in this case, the value of each share of mutual fund also drops by the amount of distribution. For example, if the share price was $20 before, and the fund makes a distribution of $3/share, then after the distribution the share price drops to $17, while each shareholders get $3 per share on which he has to pay taxes at year end.

In retirement accounts, that's not really a issue since taxes are deferred. However, if buying a mutual fund in taxable accounts, it may be better from tax perspective to delay buying until after the distribution has been made. Fortunately, most mutual fund companies list the dates of distribution on their web site, and can also provide info over the phone.

I still have to find out if the fund I am interested in buying has yet to make the distributions, otherwise, other things and expenditures will come up and I may still be in “planning to open the account" mode rather than having actually opened the account.

posted by Ruby @ 6:26 AM

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