Someone please explain - mutual funds

[RoadToRiches]

So I am reading this book "Mutual Funds for Dummies". It's VERY good book and easy to read. I already learned a lot.

I just read this thing that I don't understand. Here is what it says:

"You don’t want to jump into a fund just before it makes a large distribution.
You’re not reaping any rewards from the capital gains distribution because,
right after such a distribution, the fund’s share price decreases to reflect the
size of the payout. You are, however, effectively making yourself liable for
taxes on gains you didn’t share in.
When making purchases late in the year, find out whether and when the fund
may make a significant capital gains and dividend distribution. Fund companies
can usually tell you, in advance of the actual capital gains and dividend
distribution, approximately how much they expect the distribution to be. A
large December capital gains payout generally happens when a fund has had
a good performance year."

If I jump into a fund right before it makes distribution, then I won't get that distribution, right? So if I don't get the distribution, why would I pay taxes on it? I just don't understand.

Basically, if I am not making any "capital gains" why would I be "liable for
taxes on gains you didn’t share in"

Makes no sense to me.

[Savoir Faire-Demogague in NJ]

If I jump into a fund right before it makes distribution, then I won't get that distribution, right? So if I don't get the distribution, why would I pay taxes on it? I just don't understand.

Typically, actively managed funds distribute capital gains in December.
Say for example you put $10,000 into a fund in early December.
In mid-December the fund distributes capital gains of $1000. These are plowed back into the fund by purchasing more shares of the fund, but the Net Asset Value falls because they distributed a gain.
Since you got into the fund just prior to the distribution, your total holdings in the fund are still $10,000, but that includes a gain of $1000 that you pay taxes on.
The above is a very elementary explanation and example.

[Deleted]

If you are buying a mutual fund for the long term and plan on holding it, I would pay attention distribution timing whatsoever.

[RoadToRiches]

AHHHHHHH I get it now!

WOW, thank you for explaining!

So, let's say I keep that 10k in there for next year....and the fund distributes 1k again next December, now I will have 11k and pay for 1k of gains, correct?

What I am kind of cloudy about is, if I put 10k in early december, and fund distributes 1k, that would give me 11k. NAV drops by 1k, so I am back at 10k? So they count that 1k as gain? Seems like I am 1k short somewhere in my thinking.

[RoadToRiches]

Mar 9, 2011 9:22:33 GMT -5 ArchietheDragon said:

If you are buying a mutual fund for the long term and plan on holding it, I would pay attention distribution timing whatsoever.

Oh I know that. I am just trying to understand.

[cytoglycerine]

When a mutual fund pays out a distribution at the end of the year, it is distributing out its gains & income from the year to the unit holders so that the mutual fund itself does not pay any tax. These distributions, unless they occur in a tax-sheltered account, will create a tax liability for the unit holder of the mutual fund.


For example - You buy 10 units of a fund on Dec 30 for $10/unit ($100/total investment). On Dec 31, this fund distributes out $1/unit in gains & income from the year, so you get a distribution of $10, which will be taxable in your hands, and you are left holding 10 units worth $9 each ($90 total). So basically, you have to pay tax on $10 of "gains" when you didn't really gain anything, seeing as you just put that money in the day before.


Note - You can either take the distribution as a cash payout, or you can reinvest it in additional units but, which ever you choose makes no difference to your tax liability.


Disclaimer - I worked as a mutual fund accountant for many years, and I used to deal with all the distributions & taxation at the firm I worked for, however it is a Canadian firm, so things may be a wee bit different in the States.


ETA - Aww I typed to slow and others beat me to it!!

[Deleted]

Mar 9, 2011 9:22:33 GMT -5 ArchietheDragon said:

If you are buying a mutual fund for the long term and plan on holding it, I would not pay attention distribution timing whatsoever.

[Savoir Faire-Demogague in NJ]

Invest in index funds. They rarely pay out capital gains because they are tracking an index that would very rarely change.
The only distributions would be dividends.
Index funds are also much lower in cost.

[cytoglycerine]

Mar 9, 2011 9:28:05 GMT -5 Savoir Faire-Demogague in NJ said:

Invest in index funds. They rarely pay out capital gains because they are tracking an index that would very rarely change.
The only distributions would be dividends.
Index funds are also much lower in cost.

Agreed - Mutual funds can be horrifically expensive with their fees, and most of them do not outperform their benchmarks over the long run.

[Savoir Faire-Demogague in NJ]

Agreed - Mutual funds can be horrifically expensive with their fees, and most of them do not outperform their benchmarks over the long run.

Using index funds also makes the job of assembling an asset allocation much easier, because you know what is in the fund.
That is just my opinion.

[cytoglycerine]

Mar 9, 2011 9:33:27 GMT -5 Savoir Faire-Demogague in NJ said:

Agreed - Mutual funds can be horrifically expensive with their fees, and most of them do not outperform their benchmarks over the long run.

Using index funds also makes the job of assembling an asset allocation much easier, because you know what is in the fund.
That is just my opinion.

This is also true - It's very opaque when the MF only reports quarterly or semi-annually on what it's holdings are.


I used to hold mutual funds exclusively, but as I gained more knowledge of them, and had more experiences with the market in general, I found that I liked them less and less. I'm a born-again index fund investor now

[RoadToRiches]

"For example - You buy 10 units of a fund on Dec 30 for $10/unit ($100/total investment). On Dec 31, this fund distributes out $1/unit in gains & income from the year, so you get a distribution of $10, which will be taxable in your hands, and you are left holding 10 units worth $9 each ($90 total). So basically, you have to pay tax on $10 of "gains" when you didn't really gain anything, seeing as you just put that money in the day before."


I still don't get it. So what's the difference then WHEN I put money in? Seems like they will:

1. Give me my distribution which I will pay taxes on
2. Lower the price

So i will be back to square one regardless. ()

Let me break it down:

For example - You buy 10 units of a fund on Dec 30 for $10/unit ($100/total investment).

OK GOT THAT.

On Dec 31, this fund distributes out $1/unit in gains & income from the year, so you get a distribution of $10,

OK SO NOW I HAVE WORTH $110


which will be taxable in your hands, and you are left holding 10 units worth $9 each ($90 total).

WHY $90? THEY JUST GAVE ME A BUCK x 10? SO I SHOULD HAVE $100 AGAIN.

So basically, you have to pay tax on $10 of "gains" when you didn't really gain anything, seeing as you just put that money in the day before.

I am still missing money from my thinking.

[Savoir Faire-Demogague in NJ]

I am still missing money from my thinking.

You are over thinking it and getting tangled up in minutea.

In the long term view, it is not too relevant. You would likely be making periodic investments into the fund year round.

[cytoglycerine]

Mar 9, 2011 9:43:47 GMT -5 RoadToRiches said:

Let me break it down:

For example - You buy 10 units of a fund on Dec 30 for $10/unit ($100/total investment).

OK GOT THAT.

On Dec 31, this fund distributes out $1/unit in gains & income from the year, so you get a distribution of $10,

OK SO NOW I HAVE WORTH $110

No, you still have assets of $100 - A distribution does not affect your total assets. When the fund distributes out the $1, it lowers the price per unit by exactly the same amount, in this example, down to $9/unit. So you have $10 cash from the distribution, and you have $90 worth of mutual funds ($9/unit x 10 units originally purchased). This is if you take your distribution in cash.


If you reinvest your distributions into additional units, you still only have assets of $100. Here's how - The fund distributes out the $1/unit, and you get $10 total ($1 x 10 units), and now the units are worth $9 each. You then turn around and buy more units with your $10 distribution, but since the price of the unit has now dropped to $9, you are able to buy 1.111 units. So now you have 11.111 units (your original 10, plus the 1.111 you just bought with your reinvestment funds) that are worth $9 each, which is $100 ($9 x 11.111).


I think what is confusing you is that you're thinking of the distribution as being some kind of a payment from an outside source. It's not, it comes from within the mutual fund itself, and therefore lowers the NAV of the fund by a proportional amount.

[RoadToRiches]

oh ok, I think I get it now lol...

Yeah, my way of thinking was.. well, if I get 10 bucks on top of my 100 then I got 110 bucks! and if they LOWER NAV by what they "gave" me, then fine, ok I got $100 then.

I am just trying to understand how it works Thanks!

[cytoglycerine]

Mar 9, 2011 9:57:47 GMT -5 RoadToRiches said:

oh ok, I think I get it now lol...

Yeah, my way of thinking was.. well, if I get 10 bucks on top of my 100 then I got 110 bucks! and if they LOWER NAV by what they "gave" me, then fine, ok I got $100 then.

I am just trying to understand how it works Thanks!

No worries man! I love talking numbers and helping people understand things like this...and I've got lots of time of my hands to do it ;D


Karma for you for taking the initiative to learn how these things work. Too many people just throw their money into something they don't understand, and aren't interested in learning about.