At this time of year, you should know the ex-dividend date of the mutual funds you plan to buy. By following this advice, you will avoid some negative consequences on investment performance and taxes.
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 do not own the fund by that date, you will not receive payment. 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 NAV (net asset value).
At this time of year (October – December), most mutual funds report their dividend and capital gains distributions. You have nothing to worry about if you want to buy stocks. Such distributions do not affect the share price. However, if you own mutual funds, you should consider the impact of this distribution on NAV or share value. On the day of the distribution, you will see the NAV of your mutual fund stocks drop by the declared dollar amount. In industry parlance, we call it “buying dividends.”
Is that how it works. Throughout the year, cash from dividends paid for shares within the fund and capital gains from asset sales accumulate by adding to the fund’s cash balance or reinvested by the fund manager in shares. At the end of the year, the fund must distribute at least 95% (?) Of dividends / realized 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 fund’s NAV reflects the value of all investments it contains plus the beginning cash balance and accumulated cash from dividends and capital gains. When the fund manager distributes dividends and capital gains, the NAV drops a corresponding amount. That’s fine for people who have owned the fund for most of the year. They enjoyed the appreciation of NAV that resulted from investment growth, dividends and realized capital gains. An investor who buys just before the distribution and ex-dividend dates has bought cash value. When the fund distributes the cash, the new shareholder sees the value of his shared fund decrease, receives part of his investment, and then pays taxes, in essence, his own money! It is 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 declared a dividend of $ 3.00 per share. Doing so means that tomorrow the fund will distribute $ 3.00 of 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 didn’t enjoy the price appreciation that you would have had if you 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 buy your shares. Then you can enjoy any appreciated price all year long and pay no tax on the return of your own cash!