Avoid “Buying” Mutual Fund Dividends

At this time of year, you should know the ex-dividend date of any mutual fund you plan to buy. By heeding this advice, you’ll avoid some nasty tax and investment performance consequences.

To explain why, let me first define “ex-dividend date.” On the ex-dividend date, all registered owners of a mutual fund become eligible to receive declared dividends and capital gains distributions. If you don’t have the fund by that date, you don’t get paid. You also want to take the distribution date into account. After that date, you can go ahead and buy your shares without the negative impact on the NAV (net asset value).

At this time of year (October – December), most mutual funds declare their dividend distributions and capital gains. You don’t have to worry if you want to buy shares. Such distributions do not affect the price of the shares. However, if you own mutual funds, you should consider the impact of this distribution on NAV or share value. On distribution day, you’ll see the NAV of your mutual fund’s stock decrease by the stated dollar amount. In industry parlance, we call it “dividend buying.”

Is that how it works. Throughout the year, cash from dividends paid on shares within the fund and capital gains from asset sales are accumulated and either added to the fund’s cash balance or reinvested in shares by the fund manager. At the end of the year, the fund must distribute at least 95% (?) of realized dividends/capital gains not reinvested in new securities. Normally, the funds declare this distribution in the months of October and November.

At the end of the year, the NAV of the fund reflects the value of all the investments it contains plus the initial cash balance and accumulated cash resulting from dividends and capital gains. When the fund manager distributes dividends and capital gains, the NAV is reduced by the corresponding amount. That’s fine for people who have owned the fund for the better part of a year. They enjoyed NAV appreciation that resulted from investment growth, dividends and realized capital gains. An investor buying just before the ex-dividend and distribution dates has bought cash value. When the fund distributes the cash, the new shareholder sees the value of their shared fund decrease, receives part of the investment, and then pays taxes on, in essence, their own money from it! It’s not a good deal.

A look at an example will show you why you want to avoid buying dividends. Suppose the ex-dividend date is tomorrow and you buy shares at a NAV of $25. The fund declares a dividend of $3.00 per share. Doing so means that tomorrow the fund distributes $3.00 of the NAV, so your shares are now worth $22 instead of the original $25. You now owe taxes on $3.00 per share even though you did not enjoy the price appreciation that you would have if you had bought earlier in the year.

You can see that you lose in this situation. You should avoid buying dividends. Instead, wait until after the distribution date to purchase your shares. Then you’ll be able to enjoy any appreciated price all year long and not be taxed on your own cash back!