Vanguard is a great choice for beginning investors (and seasoned investors!), but Vanguard is not a broker. It’s a mutual fund company. Vanguard has a brokerage subsidiary, but it is primarily a mutual fund company.

What’s the difference between a mutual fund company and a brokerage firm then?

People sometimes use "broker" when they refer to either a company or a person, depending on the context. I use "brokerage firm" when I refer to the company, and "broker" when I refer to an individual person who works at a brokerage firm. The official term for the company is broker-dealer. The official term for the broker-dealer’s employee who takes customer’s orders is registered representative, or "registered rep" in short.

When you open an account with a brokerage firm, you can buy stocks, bonds, mutual funds, and ETFs. The brokerage firm is your intermediary. It holds those investment on your behalf. When you open an account with a mutual fund company, you can only buy mutual funds, and only mutual funds from that same company. You are a shareholder of the mutual funds you buy.

Every mutual fund is a separate legal entity, just like GE and GM are separate companies. Although mutual funds in the same "family" share some of the same vendors (investment advisor, distributor, and transfer agent), the funds are officially independent of each other.

When you buy mutual funds directly from the mutual fund company, you actually have an account with each and every fund you buy. This is different from a brokerage account, where you hold all the assets in one account. That’s why account statements from a mutual fund company always list the activities in each fund separately whereas statements from a brokerage firm interlace activities from different assets by date.

It becomes confusing when some mutual fund companies have a brokerage subsidiary while some brokerage firms have their own mutual funds. Still, companies are either primarily a mutual fund company or primarily a brokerage firm. Fidelity comes close to being equally strong in both. I list some of the popular companies and their primary roles here:

When a mutual fund company has a brokerage subsidiary, the accounts are distinct. You need a separate brokerage account for stocks, bonds, ETFs, and mutual funds from other fund families. When a brokerage firm has its own funds, the in-house funds are usually held in the same brokerage account together with your other assets.

Although the first question is often "Which broker?" in most cases people who just start investing don’t need a brokerage account. A mutual fund company like Vanguard will serve them well.

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It turned out it was just some year-end distributions. You probably heard or read about the usual advice “don’t buy a fund distribution” or more generically “don’t buy a dividend.” So how do fund distributions affect investors? What exactly is so bad about buying a distribution?

Let me explain with this real life example in my account. I bought only a few days before the fund made the year-end distributions. The day before the distributions, I had 262.123 shares at $7.76 per share worth $2,034.07. I received $547.66 in capital gains distribution. After the distributions were reinvested, I had 356.222 shares at $5.82 per share worth $2,073.21. More shares at a lower price. My account value actually increased. Because my fund is held in an IRA, there is no tax implication anyway.

Reminder #1: If you are investing in a tax deferred account, don’t worry about buying a fund distribution.

If you only invest in tax deferred accounts (401k, 403b, 457, traditional IRA, Roth IRA, etc.), buying a year-end distribution is not a problem.

What if it’s a taxable account? In my example, I would have to pay tax on the $547.66 distributions even if I reinvested them into the same fund. But my cost basis also would increase by the same amount. When I eventually sell the fund, I will have a smaller capital gain at that time. Therefore,

Reminder #2: Taxes paid on capital gains distributions now will be at least partially offset by lower taxes in the future.

What if I invested in a taxable account and I took the usual advice of waiting until the distributions are done? I paid $2,000 for my shares on Dec. 5. Had I known that the fund will have a large distribution in a few days and I decided to wait until Dec. 10 to make my purchase, to acquire the same number of shares I now have, I would’ve had to pay $2,073.21 on Dec. 10 whereas I only paid $2,000 on Dec. 5. The extra $73.21 due to price changes would take a big chunk out of the tax savings from avoiding the distributions while I would still have a higher capital gain and higher taxes in the future. Waiting until year-end distributions are done is not necessarily the best in all cases.

Reminder #3: Price movement can trump tax savings.

If the distribution is small, it may not be worth avoiding.

So why do they say “don’t buy a fund distribution”? Because if you do, in a taxable account, you pay more taxes now and less taxes in the future. That’s the mirror image of deferring taxes. You accelerate the taxes from the future years into the current year. You can also turn a long term capital gain in the future into a short-term gain in the current year. Short-term gains are taxed at higher rates than long-term gains.

What do you do if you invest in funds that tend to make large distributions? Such funds are said to be “less tax efficient.” First, ignore the issue if you are investing in a tax deferred account. Tax efficiency simply doesn’t affect you in 401k, 403b, IRA or Roth IRA. Second, consider if you should invest in the less tax efficient funds at all. More tax efficient funds may perform just as well after you take taxes into consideration. Third, if that’s your only choice, consider trading places with some more tax efficient funds in a tax deferred account. Move the less tax efficient fund into a tax deferred account and move some more tax efficient funds to the taxable account. Finally, harvest tax losses when you can so you have a reserve of tax losses which can be used to offset the capital gains distributions.

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