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As the end of the year draws nearer, the traditional tidings of "Merry Christmas" and "Happy New Year" have, in recent years, been accompanied by such phrases as "Look out for mutual fund year end distributions". For anyone who owns mutual funds outside of an RRSP or is considering making a large purchase before year end, the reality of such distributions will hit when tax returns are filed. Why? December is the month that many mutual funds, especially equity funds, pass through the earnings made by the fund manager over the year through to investors. In most cases these distributions are NOT prorated over the portion of the year that the investor has held the fund. Rather, the total amount to be paid is divided by the
total number of outstanding units at year end so that each unit of investment
receives exactly the same amount of distribution, irrespective of when
it was purchased. For example, suppose you purchase $20,000 of fund "X"
at $10/unit on December 14 and therefore receive 2000 units. Now if this
fund has a $1/unit distribution on December 15, a couple of things will
happen. First, the unit price of the fund will drop by the amount of the
distribution down to $9.00/unit. Secondly, you will receive $2,000 ($1
for each unit) and if this is reinvested, it will buy 222.222 more units
($2,000 divided by $9/unit). After the dust settles you now have 2222.222 units at
$9/unit for a total fund value of $20,000...the same value as before the
distribution. The differences that now you have taxable
income of $2,000 for the year just about to end. If you had waited
until December 16 to make your purchase, you could have invested your
$20,000 at the reduced $9/unit price and received the same 2222.222 units
without any prior year tax liability. This of course assumes there is
not a large fluctuation in the unit
price due to market conditions over these two days. The closer your intended purchase gets to the year end, the more you have to weigh the potential for possible market gains against the impending fund distribution. Of course the purchaser who receives the distribution is just prepaying some of the future capital gains liability because when the fund is eventually sold, their cost base will be higher and thus their future capital gains will be lower than the second purchaser. This may be easy to say, but the psychological impact of the immediate tax liability often smothers the thought of any future benefit. So, what should you do? Several things. A) Look at the past distribution history of the fund(s)
you intend to purchase. This applies to any time of year. Investigate
the track record on prior dollar amounts of distributions, and their composition
(interest,
dividends,
capital gains) as each type has a different tax treatment. Various funds
of the same class can be quite different when it comes to distributions. Of course a past history of low or no distributions doesn't mean they won't come. There is no point in selling a fund to avoid a distribution if you already have substantial built up capital gains because selling or transferring to another fund will trigger any gains and create a tax liability anyway. B) Look at the historical timing of distributions. Some funds payout regularly throughout the year so year-end purchases are not as much of a concern since a lot of the gains may already have been disbursed. C) As the year-end gets closer, call the fund company or your financial advisor as some fund companies will disclose the amount of the distributions they intend to payout. If it is late in the year, consider holding off until January to make a purchase if a large distribution seems likely and the market is not rapidly moving ahead. D) All fund families are not created equal when it comes to tax efficiency. For the truly distribution adverse investor, consider the companies that have created special classes of shares that allow investors to switch between different funds without triggering capital gains. An investor could therefore move to the money market class near the end of the year, avoiding distributions from the other classes and not triggering any capital gains. They could then move back into the other funds after the distribution has been paid.
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