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.]
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Doctor Stock says
I hadn’t seen this before… thanks for pointing it out.
I used your analysis on the spreadsheet to solve for the conditions when it’s better to buy before the distribution. At first glance you come out ahead when (1-r)D > NAV1 – NAV2 where r is the dividend tax rate, D is the distribution per share and NAV1 & NAV2 is the NAV before and after the distribution.
I don’t know much about how NAV is calculated but I assume that the fund holds some stocks and cash so NAV1=(S1+C)/S where S1 is the value of the stock before the distribution, C is the cash to be distributed and S is the total number of outstanding shares. Then after the distribution NAV2 = S2 / S. The distribution D=C/S. You can simplify the analysis above and show that it’s better to buy before the distribution when S2-S1 > rD. Obviously you don’t know the end price S2 beforehand, so when buying before the distribution you’re making the gamble that the underlying index will increase by more than the tax you pay, rD. (And I guess you won’t know the distribution you will receive either…) In your Vanguard example you’re betting that the market will move way up between Dec. 15th when they made the announcement and the 21st when they made the distribution. I wouldn’t always want to bet on that kind of timing… You’ve shown that it’s definitely possible to win out and no rule always works but it really seems like the conventional wisdom is OK. It would be neat to see a larger sample size to test which is better on average…
Sorry for the super long reply and if I understood this stuff before writing it down I probably could have jumped straight to the answer…
Can someone explain the cost basis after distribution? TFB’s spreadsheet gives it as initial investment ($10,000) + distribution – tax on distribution. It seems to me that if the distribution is not reinvested, the cost basis should remain as $10,000. If distributions are re-invested, then it should be initial cost + distribution.
What am I missing?
Thanks in advance,
Harry Sit says
@B-man – For a fair comparison between buying before and after the distribution, the spreadsheet assumes that enough is taken from the distribution to pay taxes and the rest is reinvested.
Daddy Paul says
Buy low when everyone is selling. I did not have any extra cash in March 2008. I converted a lot of my traditional IRA at that time and let Uncle Sam provide the leverage.
This is assuming the fund price is moving up in the window where entry may be made. How about in cases where price declines, e.g. current market conditions (Dec 2014), where you would then have a distribution tax PLUS a decline.
I’m not suggesting anything around directional sentiment to time your entry, but more considering the possibility that prices don’t just go up. In this alternative case of declining prices, you would theoretically still get the benefit of higher cost basis, but it is something to note that it is also possible to be holding a fund at LOWER value, and still be liable for taxes on the distribution.
I would consider the tax implications of distribution and the timing of entry based on directional bias as two independent events that each need to be aligned with your investment strategy.
Question regarding year end dividends that have declare/ex-dividend/record dates in December but don’t pay out until January…
Which year does the dividend get taxed?
I think there might be a difference if the dividend is from a stock vs a mutual fund. Don’t really care about mutual funds as I don’t seem to have any doing that. But I have several stocks that payout in January. I called fidelity and after they researched with their tax people, was told it depends on how each company decides the year to have the dividend taxed. So I asked about a couple stocks specifically and which year fidelity would put it on a 1099. Came back with they can’t provide tax advise. Thought I was specific enough to ask how fidelity would provide it to me, not personal advise.
I did search many places, but getting answers for both tax years.
Harry Sit says
The general rule: You are taxed in the year when you actually or constructively receive income.
The special rule: “If a mutual fund (or other regulated investment company) or real estate investment trust (REIT) declares a dividend (including any exempt-interest dividend or capital gain distribution) in October, November, or December, payable to shareholders of record on a date in one of those months but actually pays the dividend during January of the next calendar year, you are considered to have received the dividend on December 31. You report the dividend in the year it was declared.”
https://www.irs.gov/pub/irs-pdf/p550.pdf (page 19)
So if your dividend isn’t from a mutual fund, an ETF, a Business Development Company (BDC), or a REIT, follow the general rule.