Many taxpayers make adjustments to their investment portfolio near year-end to take profits, to recognize tax losses, to reallocate their assets, and for various other reasons. When making purchases of mutual funds near year-end, however, you should be wary of actually purchasing a tax liability.
This is the danger: mutual funds must pay out their gains and income to shareholders at least annually to avoid taxation at the fund level. Income funds and balanced funds typically make taxable distributions to shareholders either monthly or quarterly. However, equity funds often make one annual distribution at or near the fund’s year-end. These taxable distributions to shareholders reflect the income and net gains realized by the fund for the period.
An equity fund that appears to have a minimal or negative overall return for the year may actually make taxable distributions to shareholders at the end of the year. This is because of gains the fund recognized on appreciation that occurred in prior years. From an investor’s standpoint, these distributions do not result in any real net benefit; instead, the distributions are already reflected in the fund’s per share value. So after a distribution is made, the share value is reduced accordingly.
Because of the income distributions mutual funds must make, the timing of a share purchase in a particular fund can affect your tax liability. Purchasing shares just before the record date (i.e., the date that determines which shareholders will receive the distribution) is essentially purchasing a tax liability. This is because the (inflated) price of the shares just before the distribution includes the income that is about to be paid out.
When the distribution is made, the price per share falls, though the total investment value remains the same (i.e., if the income distribution is reinvested, the shareholder now owns more shares with a lower value per share; if the income is distributed, the cash received plus the share value equals the shareholder’s investment before the distribution). Thus, mutual fund investors should pay particular attention to when they invest. This is especially true for equity funds that make only one distribution each year. So be sure to check with the mutual fund company to determine the status and nature of any forthcoming dividends when purchasing equity mutual funds late in the year to avoid an unexpected tax liability.
Please contact Martini, Iosue & Akpovi by phone at (818) 789-1179 if you have questions or want more information.