Financial advisor Allan Roth has a pet peeve against the Associated Press’s habit of reporting the raw S&P 500 index changes as if they are the U.S. stock market returns. He argues the true U.S. stock market returns should (a) include dividends; and (b) include small caps. I agree with him, but the media don’t listen. Every year Allan writes a new article pointing out the same thing.
I, on the other hand, have a pet peeve against the conventional wisdom of timing mutual fund purchases around year-end distributions. Every year in late November to early December, as predictable as clockwork, there will be articles telling people to hold off investing in mutual funds until after the year-end distributions. “Otherwise you will pay taxes on gains you didn’t have,” these articles warn the investors.
Here are some examples:
- Mutual fund investors: Capital gains can hurt you at tax time, USA Today, Nov. 22, 2010
- Take care with year-end investments, Star Tribune, Dec. 3, 2010
- Year-end moves that may help lower your tax bill, The Vanguard Group, Dec. 15, 2010
For the most part, if you are investing through index funds or ETFs (why aren’t you?), timing purchases around year-end distributions is either irrelevant or penny wise pound foolish.
I say it’s irrelevant because most investors invest in tax advantaged accounts, like a 401k or IRA. The tax nuance on year-end distributions just doesn’t matter in those accounts. Considering topping off an IRA contribution? Go right ahead. Don’t worry about year-end distributions.
For taxable accounts, I gave some real world examples in my previous posts 3 Reminders About Year-End Mutual Fund Distributions and Conventional Wisdom “Don’t Buy a Distribution” Is Wrong. The same thing happened again this year. Putting off purchases until after year-end distributions made investors worse off. A lot worse in some cases.
Since we got the explicit instruction “avoid purchasing year-end distributions” from Vanguard, the mutual fund company, I looked at two popular broad market index funds from Vanguard: Vanguard Total Stock Market Index Fund (VTSAX) and Vanguard Total International Stock Market Index Fund (VTIAX). I also looked at one other Vanguard fund that had the largest year-end distribution relative to the fund price. That’s Vanguard European Stock Index Fund (VEUSX), which distributed more than 4.5% of its NAV on December 20, 2010.
I looked at three scenarios:
- Buy on Dec. 15, the day Vanguard published its warning
- Buy on the Record Date, the worst possible date according to the conventional wisdom
- Buy on the day after the Record Date, as recommended by the conventional wisdom
Here’s a summary of what happened for a $10,000 purchase under each scenario. It’s not clear at this point how much of the distributions are qualified dividend versus non-qualified dividend. For simplicity’s sake I’m assuming they are all qualified dividends, taxed at 15%.
|Total Stock Fund||Total Int’l Fund||European Fund|
|Buy on Dec. 15|
|Tax on Distribution||$8||$24||$68|
|Value after distribution and tax||$10,172||$10,097||$10,021|
|Buy on Record Date|
|Tax on Distribution||$8||$24||$68|
|Value after distribution and tax||$10,062||$9,994||$10,012|
|Buy after Record Date|
|Tax on Distribution||$0||$0||$0|
|Value after distribution and tax||$10,000||$10,000||$10,000|
For details on how these numbers are calculated, please see my spreadsheet.
In all three funds, an investor is better off buying on December 15. In two out of three funds, the investor is better off even when the purchase was made on the Record Date, allegedly the worst date according to the conventional wisdom. In the one case where the investor ends up having $6 less after paying tax on the distribution, the cost basis in the fund is $134 higher, which will reduce the capital gains tax in the future.
In the case of Vanguard Total Stock Market Index Fund, in order to defer a $8 tax, the investor would give up $172 net. That is penny wise pound foolish. In the case of the fund with the largest distribution, after paying $68 in capital gains tax, the investor is still $12 ahead, and with a $386 higher cost basis to boot.
Remember this. Don’t time your mutual fund investments around year-end distributions. It’s unproductive. I will hate to write the same thing a fourth time next year.
[I'm out of the country for two weeks. I have posts scheduled to appear automatically but I won't be able reply to comments.]