Paying taxes on dividends even though your capital gains were $0?

Question

Let's say I have $100k and decide to buy 1000 shares of some mutual fund which is currently trading at $100 a share. The next day, the fund pays out a 10% dividend, and its share price correspondingly goes down to $90.

Now I have $90*1000 = $90,000 invested in the fund, and $10*1000 = $10,000 cash from the dividends sitting in my bank account. But now I have to pay (for example) 30% capital gains tax on the $10,000. So I'm left with only $7,000 cash, or $97,000 total.

This is a net loss of $3,000 from my original $100k, in one day, without the market going down! How and why is this considered fair (and/or legal)? Shouldn't dividend taxes, like any other capital gains taxes be paid only on capital gains - i.e. on money that I actually gained due to the market moving up? In this case, my capital gains were $0, and yet I still had to pay $3,000 in taxes!

Answer 1

In the US, and in most other countries, dividends are considered income when paid, and capital gains/losses are considered income/loss when realized.

This is called, in accounting, "recognition". We recognize income when cash reaches our pocket, for tax purposes. So for dividends - it is when they're paid, and for gains - when you actually sell.

Assuming the price of that fund never changes, you have this math do to when you sell:

Basis: $100K
Dividend income: $10K
Capital loss when realized: -$10K
Tax on dividends: $3K
Tax on loss: -$3K
---------------------------------
Total: $100K

Of course, the capital loss/gain may change by the time you actually sell and realize it, but assuming the only price change is due to the dividends payout - it's a wash.

Answer 2

You are incorrect in saying that you have a capital gains of $0. You either have no capital gains activity, because you haven't realized it or you have an unrealized capital gains of -$10k. If you were to sell immediately after receiving the dividend you would end up as a wash investment wise - the 10k of dividend offsetting the 10k capital wash. Though due to different tax treatments of money you may be slightly negative with respect to taxes.

You are taxed when you receive the money. And you realized that 10k in dividends - even if you didn't want too.

In the future if this bothers you. You need to pay attention to the dividend pay out dates for funds. But then just after they payout a dividend and have drain their cash account. The issue is that you unknowingly bought 90k of stock and 10k of cash. This information is laid out in the fund documentation, which you should be reviewing before investing in any new fund.

Answer 3

I'd agree that this can seem a little unfair, but it's an unavoidable consequence of the necessary practicality of paying out dividends periodically (rather than continuously), and differential taxation of income and capital gains.

To see more clearly what's going on here, consider buying stock in a company with extremely simple economics: it generates a certain, constant earnings stream equivalent to $10 per share per annum, and redistributes all of that profit as periodic dividends (let's say once annually). Assume there's no intrinsic growth, and that the firm's instrinsic value (which we'll say is $90 per share) is completely neutral to any other market factors.

Under these economics, this stock price will show a "sawtooth" evolution, accruing from $90 to $100 over the course of a year, and resetting back down to $90 after each dividend payment.

Now, if I am invested in this stock for some period of time, the fair outcome would be that I receive an appropriately time-weighted share of the $10 annual earnings per share, less my tax. If I am invested for an exact calendar year, this works as I'd expect: the stock price on any given day in the year will be the same as it was exactly one year earlier, so I'll realise zero capital gain, but I'll have collected a $10 taxed dividend along the way.

On the other hand, what if I am invested for exactly half a year, spanning a dividend payment? I receive a dividend payment of $10 less tax, but I make a capital loss of -$5. Overall, pre-tax, I'm up $5 per share as expected. However, the respective tax treatment of the dividend payment (which is classed as income) and the capital gains is likely to be different. In particular, to benefit from the "negative" taxation of the capital loss I need to have some positive capital gain elsewhere to offset it - if I can't do that, I'm much worse off compared to half the full-year return. Further, even if I can offset against a gain elsewhere the effective taxation rates are likely to be different - but note that this could work for or against me (if my capital gains rate is greater than my income tax rate I'd actually benefit).

And if I'm invested for half a year, but not spanning a dividend, I make $5 of pure capital gains, and realise a different effective taxation rate again.

In an ideal world I'd agree that the effective taxation rate wouldn't depend on the exact timing of my transactions like this, but in reality it's unavoidable in the interests of practicality. And so long as the rules are clear, I wouldn't say it's unfair per se, it just adds a bit of complexity.

Answer 4

How and why is this considered fair (and/or legal)?

Let's use an analogy.

1. You buy a rental property. This is our (not exact) equivalent of owning a stock.
2. You will receive an income stream from the rent payments. This is our (not exact) equivalent of dividend payments.
3. The rules are that you report the income from the rent.
4. The rules are that you report the gains/loss when you sell the house. Of course, you can report depreciation yearly as well, changing your cost basis. This is our (not exact) equivalent of stock sale and loss harvesting.

The issue is not fairness, it is just the rules. The assets you own and the cash you receive are reported differently.

If the rules don't make sense, I suggest you hire an adviser that can teach you and help you get the most out of your investments.

Answer 5

The issue for you seems to be the sequence of events. Presumably, there will be a gain in the fund. In one year, you have a fund worth $100,000 and the $8500 your netted from the $10,000 dividend. (Dividends are taxed at 15% for most of us. If your taxable income is under $38K single, it's $0) An $8500 net return for the year.

Now, if there were no initial dividend, and at the end of a full year, your $100K grew to $110K, and then gave you the $10K dividend, you might not be so unhappy.

Even on day 2, you now have a fund worth $90K with a basis of $100K, and the promise of future dividends or cap gains. When you sell, the first $10K of gain from this point will effectively be tax free due to this quick drop.

To directly answer the last few sentences, dividends and cap gains are different. And different still, for the way a fund processes them.