Timing of selling shares of mutual funds with respect to tax and investment income distribution

Question

When planning to buy shares of a mutual fund, if I understand correctly, it is better not to buy at a time right before the fund distributes its investment income to its shareholders, since the new shareholder has to pay tax on the investment income before his share value actually increases.

Similarly, when a shareholder plan to sell his shares of a mutual fund, I was wondering if there is some consideration about the timing of selling with respect to the timing of investment income distribution by the fund? For example, do you suggest to sell the shares right before or after the fund distribute its investment income?

Thanks and regards!

Answer 1

I will give a somewhat different answer from JoeTaxpayer's answer, though I fully agree with his first sentence.

What is it you want to do?

• Sell a fixed number, say 100, shares of a mutual fund regardless of the price?

• Sell enough shares to raise $1000 cash?

• Or sell your entire investment in the mutual fund because you just want out?

In the days leading up to a distribution from a mutual fund (which, by the way, is announced ahead of time together with an estimated amount of the distribution), the price of shares in the fund includes the value of the distribution. Suppose that it is a long-term capital gain distribution. Some share holders will have told the fund that they will take the distribution as cash, others that they will reinvest in the fund, and so the fund will be holding some cash to pay out to folks taking the distribution as cash. Suppose the fund has announced that it will be distributing a $1 dividend per share, and the current share price is $11. Immediately after the distribution, the share price will be $10. If you hold 500 shares and opted to take cash, you will get a check for $500, and of course you will continue to hold the same 500 shares which are now worth only $10 each. But no change in wealth: you had $5500 invested in 500 shares before the distribution, and you have $5000 invested in the same 500 shares and $500 cash. If you opted to reinvest, you will be sold 50 shares ($500 divided by new share price of $10) and now be the proud owner of 550 shares valued at $10 per share. So, before the distribution, you had $5500 invested in 500 shares in the fund; afterwards you have $5500 invested in 550 shares at $10 each, that is, no change in wealth. And in either case, you have $500 taxable long-term capital gain.

So, if you want to sell 100 shares, you will get $1100 before the distribution, but only $1000 afterwards. Whether you have a capital gain or loss resulting from the sale depends on which shares you choose to sell and at what price you bought them.

If you want to raise $1000, you will need to sell fewer shares before the distribution and more afterwards (unless you took the distribution as cash and are counting it towards the $1000 to be raised). Again, capital gain or loss from the sale depends on which shares you choose to sell and at what price you bought them.

If you want out completely, you will get $5500 either way, before the distribution or afterwards. If you bought all 500 shares for $10 each, then you will have a long-term capital gain of $500 upon selling them for $11 each just before the distribution. You will get a Form 1099-B from the fund and report this gain on Schedule D. Selling the 550 shares right after the distribution (or taking the distribution in cash and selling the 500 shares after the distribution) will give you no capital gain from the sale but you will have a $500 long-term capital gain from the distribution that will be reported on a Form 1099-DIV and will also be reported on Schedule D on a different line (but be taxable nonetheless). On the other hand, if you had bought the shares for $11 each, then there is no capital gain if you sell before the distribution, while if you sell after the distribution (at $10 per share), then you have a capital loss of $500 on the sale which will cancel out the capital gain from the distribution, that is, no gain or loss regardless of which choice you make: sell before the distribution or after. Have fun working out what happens in you bought those shares in dribs and drabs and at different prices over the years.

Answer 2

One should not let the tax tail wag the investing dog.

I spy a fund that I feel is right for the long term, but on the $10000 purchase, I fear a $1000 cap gain distribution, so I wait. The fund (and market) have a great month, and the $10000 would have risen to $11000. Those who bought are pretty happy despite the distribution they reinvest. Your question is valid, but when you understand that over the long term, these things should have no effect on your actions, you'll be a better investor.