Most stock funds distribute capital gains and income to shareholders at the end of the year, usually in December. You’ll find estimated distributions on most fund websites.
If you own funds in a taxable account, these distributions are taxable to you, so you’ll want to pay attention to these estimates and decide how to handle them.
If your fund is planning to pay a distribution, you have three choices:
(1) Hold the fund and receive the distribution.
(2) Sell the fund before the record date to avoid the distribution.
(3) Sell the fund after the distribution.
Which choice is right for you?
Here are a five key questions that can help you decide how to move forward.
1. How long have you owned the fund?
If you sold the fund, would you realize a long-term or a short-term gain?
2. How much of a gain or loss do you have in the fund, and how does that compare to the amount of the fund’s distribution?
If you hold the fund and take the distribution, you’ll pay tax on the distribution. If you sell the fund to avoid the distribution, you’ll owe taxes on any gains you realize.
3. How much of the fund’s distribution is long-term capital gains, short-term capital gains or income?
Long-term gains are preferable because they’re taxed at a lower rate than short-term gains or income.
4. If you sell the fund, what will you buy instead?
If you decide to sell a fund, you should also have a plan for what you’ll do with the proceeds. Remember that if you sell a fund to realize a loss, you shouldn’t buy back into that fund for at least 30 days. If you do, you’ll trigger a “wash sale” and you won’t be able to use the loss to offset other gains.
5. Is there an advantage to selling the fund after the distribution?
A fund’s NAV (price per share) drops by the amount of its distribution, so after the distribution you may be holding the shares at a loss (if the distribution was greater than the gain you’d had in the fund before the distribution). In that case, you can immediately sell the shares to realize the loss, and in some cases, the distribution could effectively to turn a short-term gain into a long-term gain!
Complex but rewarding work
As you can see, deciding how to best handle a distribution depends on your circumstances. There's no one-size-fits-all answer.
We’ve been doing this work for decades for our private clients, and it still takes time and careful analysis of each fund and trade lot. Every year is different, and the right answer for one client isn’t necessarily right for another.