Year-End Distributions – What You Need to Know

As Andy Williams said, it’s the most wonderful time of the year. Nope – it’s not the holidays, not egg nog, not Santa…it’s year-end distributions!

Throughout the year, we look for ways to avoid taxes on distributions, so the items we plan to discuss are either already done or in progress. But hopefully this should help you understand what to expect as they pay out, and serve as guidance for investments you may have outside of BDF.

 The Basics:

Distributions generally consist of dividends, capital gains and interest from the underlying securities in an investment fund. Capital gain distributions are due to the fund selling securities, incurring gains, and distributing those to shareholders.

Every year, we get questions on this. The most common include:

  • Should I buy this investment before it pays, so I can receive it?
  • Should I wait to sell my investment until after the distribution pays?
  • The price of my shares fell for no reason. Help!!!

To answer these, it may be helpful to explain how the dates and the corresponding math work:

  • The Record Date – is the cutoff date set by the investment company to determine which shareholders are eligible to receive distributions.
  • The Ex-Dividend Date –If you buy or own a fund before this date you will receive the distribution, usually the following day. However on this date, the price of the fund drops roughly by the amount of the distribution being paid, not accounting for market fluctuations. Conversely if you buy a fund on or after the ex-dividend date, you will not receive the distribution.
  • The Pay Date – On the actual pay date (often at least a day after the ex-dividend date), you get the cash.

Therefore, once a distribution occurs, you essentially end up in the same spot you started. Here’s an example:

  • You own a fund worth $10. It will pay a capital gain distribution of $1 per share.
  • On the record date – the company determines if you are eligible to receive the distribution.
  • On the ex-dividend date – the price of your share drops by the distribution amount, to $9.
  • On the pay date (the next day) – you get the $1 of cash.

As you can see, if you add both numbers together you still have $10. But now, $1 is in the form of cash. Further, if you own that fund in a taxable account, you pay tax on that $1.

Therefore, buying a fund immediately before distribution is something to avoid in taxable accounts. Essentially all this does is increase your tax bill.

Should you hold funds that are paying a distribution? It depends:

  • For qualified accounts like IRAs and 401(k)’s, yes – since you will not be taxed. This is why we utilize asset placement, i.e. putting tax-inefficient assets in qualified accounts, to increase after-tax returns.
  • For taxable accounts, maybe. This may not make sense if the investment is trading at a loss however, or if the amount of gain you realize by selling is substantially less than the gain being distributed.

Why does the price drop? This is due to the lag between the ex-dividend and the pay date. It’s unsettling to see your account drop on the ex-dividend date, which can lead to rash investment decisions. Just remember the cash will come later, so don’t worry – it’s just timing.

We of course work on managing all these things on your behalf every day.  Enjoy the holidays, and hopefully higher after-tax returns as well! As always, please contact your team if you have any questions.