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Doing Some Last Minute Shopping? Don’t Buy a Tax Bill

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As the year comes to a close, there are a lot of different reasons why you might be considering investing in (buying) a mutual fund. Perhaps you got that Christmas Bonus…o.k. I know you’re on Active Duty and Uncle Sam hasn’t found it in his heart to give Christmas bonuses yet, so maybe your spouse got it. Or, perhaps you sold a security at a loss to reduce your tax bill and now you are looking to invest somewhere else. Or, just maybe, Santa has been very generous and you have some money to invest. No matter the reason, if you are thinking about investing in mutual funds before the end of the year, you want to be careful or you could just end up buying a tax bill too. Now, if you’re considering making your investment through a tax-free or tax deferred account this isn’t an issue. But in pretty much all other situations it is. Let me explain.

Mutual Funds, in order to avoid taxation themselves, pass on “substantially all earnings” to taxpayers each year. Depending on the fund, a large portion of this distribution can occur in December. The taxpayer who receives the distribution, regardless of how long the taxpayer has owned the fund, is liable for the tax due. Whether you receive the distribution or not depends on whether you owned the mutual fund on the ex-dividend date. This tax is due regardless of whether you receive the distribution in cash or reinvest it in the fund. An example might explain best:

  1. Mr. Taxpayer buys 10 shares of Good Investment Mutual Fund (GIM) at $10 per share ($100 total investment) on the day before earnings distributions.
  2. The next day, GIM distributes $1 per share in earnings.
  3. Mr. Taxpayer has elected to have the earnings reinvested in GIM.
  4. After the distribution GIM is now valued at $9 per share, so Mr. Taxpayer “purchases” 1.1111 shares of GIM with his distributed earnings.
  5. After the distribution and reinvestment, Mr. Taxpayer owns 11.111 shares of GIM valued at $100.
  6. Mr. Taxpayer now owes between $1.00 and $3.00 in federal income tax depending on his exact tax situation.
  7. As a result of the transaction and tax ramifications, Mr. Taxpayer has actually decreased his net worth by the tax bill and he hasn’t made a cent of profit.

Mr. Taxplanner, on the other hand, waits until after the distribution to buy the shares. His scenario looks like this:

  1. Mr. Taxplanner buys 11.111 shares of GIM on the day after the earnings distribution for $9 per share ($100 total investment).
  2. Mr. Taxplanner owes no taxes related to GIM.
  3. Mr. Taxplanner suffers no loss in his net worth.

So, what to do with this information. Well, if you are considering investing this month make sure you check out the Mutual Fund’s web page or call them on the phone and determine when the earnings will be distributed. Don’t assume that it has occurred since it is late in the month already. Often times, the distributions don’t occur until the last day or two of the year. Once you have the schedule for the distribution, time your purchase to occur after the earnings distribution occurs. That way you’ll minimize your taxes and not negatively affect your net worth.

Curt Sheldon is a Fee-Only Financial Planner based in Northern Virginia.  He can be contacted at (703)542-4000,  (800)928-1820 or Curt@CLSheldon.com

IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication

The information contained in this blog is for general financial education and should not be construed as individual financial advice.  Please consult your own financial, tax or legal advisor prior to applying any principles discussed here to your own financial situation.