Year end fund distributions can create tax headaches for some investors
One question that I often get asked by investors is “when is a good time to invest?” Generally, the answer is to invest when you have the money and put it into a well diversified portfolio that is in line with your investment objectives, risk tolerance and time horizons. If you are looking to invest in a non registered account and you ask me that same question today with the end of the year fast approaching, I will tell you to hold off to the New Year.
I should point out that I don’t expect a big selloff between now and the end of the year. My concern is that as the end of the year approaches, many mutual funds and ETFs will be getting into the holiday spirit by giving their investors “gifts” in the form of year end distributions. Normally, gifts are considered a good thing. However in the case of year end distributions, for unsuspecting investors, they can be anything but good. In fact, they may be harmful to your financial health since they will result in you having to pay taxes on them.
Along with the tax issues, it is important to point out that distributions from funds are not an indication of investment quality like they can be with stocks. With a stock, dividends indicate that the company is profitable and generating excess cash that they wish to distribute back to their investors. It is a much different situation with funds because they are required to pass along any taxable income they earned over the course of the year to investors. In other words, year end fund distributions are not about rewarding investors by paying them excess cash the fund has earned, but rather transferring a tax liability to investors.
It is also for this reason that even funds which have lost money over the course of the year can still have a significant year end distribution. This not uncommon occurrence will typically happen with funds that engage in frequent trading or when a fund sells out of a long standing holding on which they have held for a very long time and have made a lot of money over the years.
When the fund declares the distribution, those who hold the fund on the date of record will receive the entire distribution. This is true whether you held the fund all year, or for only a couple of days. It is because of this that investors in taxable accounts need to exercise caution when making any new investments as the end of the year approaches. The last thing you want is to incur a tax liability on an investment you just bought.
We should also point out that in the eyes of the Canada Revenue Agency, there is no difference between receiving your distributions in cash or having them reinvested back into the fund. It is still a transfer of tax liability on which you must pay tax.
Perhaps the most frustrating thing about these distributions is that investors are no further ahead when a distribution is paid than they were before. In fact, in non registered accounts, they are actually worse off. Let’s take a look at a very simple example.
Let’s assume that you held 10 units of a fund that had a net asset value of $10. The total value of your investment would be $100. On December 31, they declare and pay a distribution of $2 per unit. Instinctively, you would think that you would be better off because you would be receiving an additional $20 ($2 distribution X 10 Units). Unfortunately with a fund investment, the distribution isn’t added to your investment. Instead, it automatically reduces the net asset value of the fund by the exact amount of the distribution.
If you received the distribution in cash, the net asset value would automatically fall from $10 to $8 and you would receive $2 in cash for each unit you held. In this case, you held 10 units, so the value of your units would fall to $80 and you would have $20 cash for a total of $100. Furthermore, you would have to pay tax on the $20 dollars.
If you were to have the units reinvested, again, the price per unit would automatically drop to $8 and the additional $2 would be used to buy new units. In this example, the distributions would buy an additional 2.5 units, bringing your total up to 12.5 units. With each unit now having a net asset value of $8, the total value of your investment remains at $100 and you have again been hit with a $20 tax liability in a non registered account.
Bottom Line: Year end fund distributions are an unfortunate fact of investing. For investors who are looking to make some changes or additional investments into their non registered portfolios, the potential damage of these distributions can be reduced by holding off and investing in the New Year or after the distributions have been paid. Before investing in a non registered account, check with the Fund Company or ETF provider to see if they can give you an estimate of the expected distribution. These estimates are usually available in early to mid December.
Some critics will point out that by holding off buying a fund until after the distribution that you are pushing the tax liability down the road. That may very well be the case, but nobody likes to pay taxes and if you can hold off on that as long as you can, why wouldn’t you do that?