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Explaining Year End Mutual Fund Distributions

Explaining Year End Mutual Fund Distributions

December 16, 2021

Mutual Funds are required to distribute capital gains at end of year, often leading to unusual daily price movements.  How this works.

Stock mutual funds own hundreds, or even thousands of individual stocks.  During the course of the year, funds will buy and sell stocks, either to maintain their investment strategy, or to invest new money, or generate cash for investor redemptions. 

When you as an individual buy or sell a stock, you incur a capital gain or loss on that transaction.  When the fund company buys or sells a stock, those gains or losses also must flow through to the shareholders.  The way fund companies do this is by creating a once a year “dividend” distribution, usually in December, which is reported to the IRS as a capital gain for the investor.

Here is the way it works. 

Lets say a fund starts the year with 10000 in various company stocks.  There are ten investors who own the fund, who own 1 share each. Each share is worth 1000 each.  

During the course of the year, the fund sells a stock for a 1000 loss, and sells another stock for a 2000 gain.  At the end of the year, they net up their gains and losses (just as we all would do in our taxable investment accounts) and realize a $1000 gain.  Lets assume that the other stocks in the fund lost value, so that the total value of the fund is still $10,000 at the end of the year.  

Per IRS regulations, they have to distribute that $1000 gain to the investors.  So they sell send each of the 10 investors their share of the gain as a “dividend” of $100.  This is reported to the IRS (if it is a taxable account) on the brokerage firms 1099 as a capital gain.  The fund is now worth only $9000, because they sent the investors $1000 in cash.  So each share loses $100 in value, while the investor receives an equivalent $100 in cash.  Everyone still has $1000 at the end of the day.  

Now here is where it gets complicated.  Most investors probably have setup their accounts to reinvest such dividends by buying new shares in the fund.  This creates some interesting price dynamics on the day the distribution is made by the fund company.  As explained above, the investors $1000 investment in the fund appears to decline by the amount of the distribution.  This is because the $100 is taken out of the account on the day the dividend is declared.  But if the dividend is being reinvested, that transaction won't happen until the following day.  On the second day the $100 which effectively “disappeared” the day before suddenly reappears as new shares in the mutual fund as the dividend is reinvested.  The fund balance (absent any price movement in the interim) is exactly what it was before the distribution occurred.  The capital gain has no net effect on the value of the investors holdings. 

If the fund is held in a retirement account, that is the end of the story.  In a taxable account, however, there IS an impact on the cost basis of the fund.  Because the dividend is being reported as income and is buying new shares, and the new shares are being purchased at today’s price, the cost basis of the investors holdings will increase.  This will reduce the tax burden on any future sale of shares. 

Some years, funds won’t make any distribution at all.  This might be because the net result of the funds buy and sell activity was a loss.  Or it may be that previous year’s losses are being carried over to reduce this year’s gain.  Actively traded funds will generate larger gains than “passive” index funds – but even index funds will generate some gains.

Many investors find this whole thing confusing.  And admittedly it may be more information than you needed to know.  But if you find yourself wondering about unusual gyrations in an investments value this time of year – this is your explanation!   Hope it makes sense.