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A few years ago I bought a mutual fund in late November, and unbeknownst to me, the fund was set to do an annual dividend distribution about 3 weeks later in mid-December.

I bought 5000 shares at $10 per share (for $50000 total), and the dividend was about 10%. When I got the dividend notice in the mail, it indicated that the new share price was $9 per share, and I now own 5555 shares (but my total account balance was unchanged, and still stayed at $50000).

However, (and this is the question), they also declared in my end-of-year tax notice that this dividend gave me a taxable capital gains distribution of $5500, which I owed income tax on. How is that possible?? My account balance never changed, and had I made no actual money yet, but somehow I owed taxes? (note that this year was an overall losing year for the fund, with a negative return)

The next year, I received a similar annual dividend in December, but this time my account balance increased by the 10% of the dividend, so having taxable capital gains was appropriate. (also note that this was a positive year for the fund)

I just called the fund twice to ask this, and the phone reps seemed unable to grasp my question, and only could say "well, you received a dividend and dividends are taxable." But I gained absolutely nothing from my dividend, so how is it taxable?

Did I get screwed the first year because I bought into the fund too late in the year? I'm looking at buying again now since the price is good, but I don't want to get hit with another phantom taxable distribution.

Is anyone familiar with what causes this kind of situation of receiving a "taxable dividend" that doesn't actually increase the account balance? Is it because I bought too late in the year? Or is it because the fund had a negative return that year? Do I wait until after the distribution date this year to buy?

Thank you.

  • bonds.about.com/od/bondfunds/fl/… would be an article about distributions as I wonder if you understand the implications of mutual funds not paying taxes but rather having to distribute those to shareholders as some may hold the funds in tax-advantages accounts like 401k and IRAs. – JB King Nov 18 '15 at 21:18
  • have you considered a similarly invested ETF? that tax burden was frustrating to me enough to move to the different vehicle. – neuralstatic Nov 19 '15 at 2:20
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How is that possible??

The mutual fund doesn't pay taxes and passes along the tax bill to shareholders via distributions would be the short answer. Your basis likely changed as now you have bought more shares.

But I gained absolutely nothing from my dividend, so how is it taxable?

The fund has either realized capital gains, dividends, interest or some other form of income that it has to pass along to shareholders as the fund doesn't pay taxes itself.

Did I get screwed the first year because I bought into the fund too late in the year?

Perhaps if you don't notice that your cost basis has changed here so that you'll have lower taxes when you sell your shares.

Is anyone familiar with what causes this kind of situation of receiving a "taxable dividend" that doesn't actually increase the account balance?

Yes, I am rather familiar with this. The point to understand is that the fund doesn't pay taxes itself but passes this along. The shareholders that hold funds in tax-advantaged accounts like 401ks and IRAs still get the distribution but are shielded from paying taxes on those gains at that point at time.

Is it because I bought too late in the year?

No, it is because you didn't know the fund would have a distribution of that size that year. Some funds can have negative returns yet still have a capital gains distribution if the fund experiences enough redemptions that the fund had to sell appreciated shares in a security. This is part of the risk in having stock funds in taxable accounts.

Or is it because the fund had a negative return that year?

No, it is because you don't understand how mutual funds and taxes work along with what distribution schedule the fund had.

Do I wait until after the distribution date this year to buy?

I'd likely consider it for taxable accounts yes. However, if you are buying in a tax-advantaged account then there isn't that same issue.

  • Thank you for the detailed answer, that is helpful. I did notice that my basis was higher than I thought it should be though, and wasn't about to complain, and never thought to correlate that to this event (I have an accountant who handles all these details). – Nick Nov 18 '15 at 22:07
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No, not screwed. This is just an artifact of the tax code and year end dividends.

You paid a tax, and in return, got a higher basis. When you sell, you will have less profit, therefore less tax to pay than the guy who bought right after the dividend.

You can call the fund company if you want to buy later this year. Once you understand the process, it might not bother you at all.

  • @blm - I saw a deleted comment. You are right, the basis rose, I edited my answer, which should now make more sense. – JoeTaxpayer Nov 18 '15 at 21:31

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