Posted by Don Martin on Wed, Nov 21, 2012 @ 08:39 AM
Mutual Fund Distribution Season Creates Tax Traps
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Mutual funds make annual distributions in November and December. People ask how can they avoid a mutual fund distribution? These are created when the fund sells off profitable investments, thus generating a capital gain which must be distributed to the shareholders. This can happen even if the value of the fund is going down.
This tends to happen after a long bull market the fund’s assets have appreciated and if too many investors want to sell their shares in the fund then the fund must sell some investments so that triggers a capital gain transaction which flows through to the mutual fund shareholder. So if a mutual fund bought an asset for $10 a share and after a long bull market years later the asset is worth $50 and then the market crashes then people will take their money out of the fund so the fund must sell the $50 asset, thus realizing a $40 profit. The $40 profit is shared with the mutual fund shareholders. So ironically just after the top of a bull market is when you may get a distribution (of capital gains) even though the mutual fund is going down in value.
A distribution may occur because the fund manager decided that the asset had reached a top and so he or she sold it to buy an undervalued asset. In that case he or she was doing the right thing even though it cost you some taxes. But if you had invested on your own with no mutual fund then you should have done the same thing to avoid holding an overpriced asset even if it means paying taxes. The problem is that if you bought a fund in October that had already generated a taxable sale of its assets in the early part of the year then you will get stuck paying tax on the distribution if you own shares during the November-December distribution season.
Mutual fund managers seek to avoid causing this problem so they try to sell the high basis tranche of an appreciated asset, but sometimes they have no choice but to sell low basis assets
A distribution is merely an accounting entry; there is no need to actually distribute cash in order for a mutual fund to create “distribution” on a 1099 tax report. However the custom is for the fund to give some cash with the “distribution” so that the taxpayer has some cash to pay the tax.
I remember a long time ago before I was a licensed Investment Advisor I bought a mutual fund and got a distribution of a few hundred dollars and the fund then went down in value by a tiny amount because of the payment of a cash distribution. So I had “phantom income” from the distribution but in the real world my fund shares dropped in value. This is because profitable assets had been sold by the fund company earlier in the year, before I bought the fund, thus incurring capital gains and these gains were attributed to shareholders near the end of the year. So by paying a few hundred in “tuition” in the real world I learned how important it is to be alert to this problem. By looking out for over-priced bubble tops one can increase the chances of avoiding unjust distributions, so the principals of good investing can help to avoid tax traps.
Will I have to give a pile of money to the IRS?
To avoid this problem:
- Only hold mutual funds in tax deferred 401K’s or IRA (not recommended)
- Only buy mutual funds after the annual distribution has taken place (not recommended)
- Buy ETF’s (not recommended)
- Buy mutual funds that invest in assets that are undervalued, that are at the beginning of a new bull market. Never buy a mutual fund with appreciated assets at the top of a bull market because the assets are overpriced and will go down.
The problem with #1 is that assets that produce capital gains should be held in a taxable account because capital gains in a 401k or IRA are treated as ordinary income. The problem with #2 is that the problem of an unwanted distribution is not as important as that of simply avoiding the purchase of an overpriced top of the bubble asset. The problem with #3 is that ETF’s are passive vehicles that have tracking error problems and in some cases do not perform as well as a good active mutual fund.
The key to avoiding distributions is the same as the key to good investing: avoid buying at the top of a bubble and instead buy at low prices at the beginning of a bull market and sell appreciated assets when they reach the top of a range of values. The tax problem is simply a reinforcement or enhancement of the problem caused by buying an overpriced asset at the top of the market. Only buy and hold low proced assets; avoid buying overpriced assets.
I have written an article “Dangers of mutual fund distributions”
Investors should seek independent financial advice.
Posted by Don Martin on Wed, Nov 09, 2011 @ 02:37 PM
Mutual Fund Distribution Season Creates Tax Traps
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Mutual funds make annual distributions in November and December. People ask how can they avoid a mutual fund distribution? These are created when the fund sells off profitable investments, thus generating a capital gain which must be distributed to the shareholders. This can happen even if the value of the fund is going down.
This tends to happen after a long bull market the fund’s assets have appreciated and if too many investors want to sell their shares in the fund then the fund must sell some investments so that triggers a capital gain transaction which flows through to the mutual fund shareholder. So if a mutual fund bought an asset for $10 a share and after a long bull market years later the asset is worth $50 and then the market crashes then people will take their money out of the fund so the fund must sell the $50 asset, thus realizing a $40 profit. The $40 profit is shared with the mutual fund shareholders. So ironically just after the top of a bull market is when you may get a distribution (of capital gains) even though the mutual fund is going down in value.
A distribution may occur because the fund manager decided that the asset had reached a top and so he or she sold it to buy an undervalued asset. In that case he or she was doing the right thing even though it cost you some taxes. But if you had invested on your own with no mutual fund then you should have done the same thing to avoid holding an overpriced asset even if it means paying taxes. The problem is that if you bought a fund in October that had already generated a taxable sale of its assets in the early part of the year then you will get stuck paying tax on the distribution if you own shares during the November-December distribution season.
Mutual fund managers seek to avoid causing this problem so they try to sell the high basis tranche of an appreciated asset, but sometimes they have no choice but to sell low basis assets
A distribution is merely an accounting entry; there is no need to actually distribute cash in order for a mutual fund to create “distribution” on a 1099 tax report. However the custom is for the fund to give some cash with the “distribution” so that the taxpayer has some cash to pay the tax.
I remember a long time ago before I was a licensed Investment Advisor I bought a mutual fund and got a distribution of a few hundred dollars and the fund then went down in value by a tiny amount because of the payment of a cash distribution. So I had “phantom income” from the distribution but in the real world my fund shares dropped in value. This is because profitable assets had been sold by the fund company earlier in the year, before I bought the fund, thus incurring capital gains and these gains were attributed to shareholders near the end of the year. So by paying a few hundred in “tuition” in the real world I learned how important it is to be alert to this problem. By looking out for over-priced bubble tops one can increase the chances of avoiding unjust distributions, so the principals of good investing can help to avoid tax traps.
Will I have to give a pile of money to the IRS?
To avoid this problem:
- Only hold mutual funds in tax deferred 401K’s or IRA (not recommended)
- Only buy mutual funds after the annual distribution has taken place (not recommended)
- Buy ETF’s (not recommended)
- Buy mutual funds that invest in assets that are undervalued, that are at the beginning of a new bull market. Never buy a mutual fund with appreciated assets at the top of a bull market because the assets are overpriced and will go down.
The problem with #1 is that assets that produce capital gains should be held in a taxable account because capital gains in a 401k or IRA are treated as ordinary income. The problem with #2 is that the problem of an unwanted distribution is not as important as that of simply avoiding the purchase of an overpriced top of the bubble asset. The problem with #3 is that ETF’s are passive vehicles that have tracking error problems and in some cases do not perform as well as a good active mutual fund. So the key to avoiding distributions is the same as the key to good investing: avoid buying at the top of a bubble and instead buy at low prices at the beginning of a bull market and sell appreciated assets when they reach the top of a range of values.
I have written an article “Dangers of mutual fund distributions”
Investors should seek independent financial advice.
Posted by Don Martin on Mon, Jun 06, 2011 @ 02:24 PM
Mutual funds with no distributions
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When you own shares in a mutual fund you may get dividends from the fund company that were from the dividends earned by the individual stocks held by the fund. In additional you may get a “distribution” of short term and long term capital gains. These are usually issued in November or December.
Investors don’t like getting distributions from a mutual fund because this means taxes have to be paid. Investors emotionally feel that they should only have to pay tax when they take the initiative to sell an investment. However a mutual fund is a collective investment and when the fund manager sells assets then that may trigger a capital gain which must be paid by the individual shareholders because a mutual fund is a “pass-through” entity where taxable events in the fund are passed through to the individual shareholders.
Methods to avoid capital gains distributions:
- Hold mutual funds (that you suspect will give a distribution) in a traditional IRA. However that causes a worse tax problem: traditional IRA’s wash out the tax treatment of dividends and long term capital gains and convert them to ordinary income. So in most cases it would be very wrong to do this. Of course a Roth IRA is tax free, so that would be different.
- By mutual funds after the annual distribution has occurred. The problem is that investing (in theory) should be for the long run, so buying a fund in December and selling in October just to avoid distributions is wrong and impractical and would trigger short term gains tax (if it was profitable) on your sale of the mutual fund.
- Buy ETF’s to avoid capital gains distributions. They obtain shares of stocks through “creation units” which have a different tax consequence when these units are redeemed by an “authorized market maker” from a mutual fund. Unfortunately the goal of pursuing tax savings is trumped by the goal of getting good investments. I don’t recommend passive ETF’s because I believe in actively managed mutual funds. If an investor is trying too hard to chase after tax benefits an investor may not be able to make the right investment decisions.
- Recognize that distributions often occur for a reason: They may occur at the top of a bubble or just after the top when investors withdraw funds from a mutual fund the manager needs to sell assets to pay the investors who are redeeming mutual fund shares. These sales then trigger a distribution which is assessed on the remaining shareholders. So the best defense against distributions would be to avoid funds that are part of a bubble top because the fund’s assets will go down in value and will be sold to meet redemption requests. Thus you get two benefits by avoiding bubbles. Now the question is how do you spot and avoid bubbles? This is the real question that is far more important than avoiding distributions.
Risk of a pyramid?
To avoid bubbles one should avoid over-priced investments and be a contrarian and avoid investing in what the masses believe in. Avoiding over-priced investments means watching the P.E. ratio and buying when it is at a discount below fair value and then selling assets when the P.E. is too high. This is one of many indicators. In some cases a low P.E. ratio is a “Value trap” where a P.E. ratio is low because a company is going to fail soon. So besides buying at the right price the assets purchased must be quality assets. “Quality” means stable, healthy earnings which is something the dotcom bubble stocks did not have. It also means low debts, a good corporate moat, good corporate governance (not opaque or manipulative behavior).
I am concerned that the commodities boom was a panic caused by speculators and by China worrying too much about dollar devaluation. I expect China’s economy to cool off and commodity speculation to collapse as it did in 2008. This will provoke investors in developed countries to become bearish about developed country stocks and then they will go down.
I have written “U.S. equities are 70% overpriced”.
The Emerging Market economies are more fiscally sound than the U.S., so they may be a place to invest for the purpose of reducing the risk of dollar devaluation, or the risk of developed country government insolvency. Important: Get more information in my free Special Report about emerging market currency investing.
Investors should seek independent financial advice.