Is there an optimal time to sell fund shares based on the ex-dividend date?
QUESTION: I'm selling some mutual fund shares. Is there an optimal time of the year to sell based on the ex-dividend date? What's a good strategy for liquidating my holdings?
ANSWER: A timely question. For those looking to unload fund shares before the end of the year, there could indeed be a tax benefit to selling before the fund's year-end distribution (which takes place on the ex-dividend date). But to reap this potential reward, the shareholder must have owned the fund for more than 12 months, and, obviously, the fund must be anticipating a distribution.
The reason for this potential tax perk is that year-end distributions can include dividends, interest and short-term capital gains -- all of which are taxed as ordinary income. By selling before this distribution, these gains will instead be taxed as long-term capital gains (again, assuming you've held the shares for more than 12 months), which for most folks is 20%, explains Joel Dickson, a tax-efficiency expert at the Vanguard Group. Particularly for those in higher tax brackets, this savings could be meaningful.
Of course, nearly three years into this bear market, relatively few funds will be issuing distributions this year, says Scott Cooley, senior analyst at investment-research firm Morningstar. And selling a fund before a distribution that consists only of long-term capital gains isn't going to provide a tax benefit, because, after a distribution, the fund's net asset value (NAV) drops to reflect that distribution. So if you're selling at a long-term gain, it will be taxed the same either way. And if you're selling at a loss, you'll have a greater long-term loss to write off — which will balance out the long-term gain that's distributed.
(Confused? Consider this example. Say an investor purchases 1,000 shares of a mutual fund with an NAV of $5 per share. The investment is therefore worth $5,000. She then holds the fund more than a year, during which time the NAV rises to $10 per share, which means the investment is now worth $10,000. The fund then announces a $1 long-term capital-gain distribution per share. Should the investor sell before the distribution she'd have a $5,000 long-term capital gain. If she waits until after the distribution, she'd have a $1,000 long-term-gain distribution from the fund. At the same time, the NAV has dropped to $9 a share from $10. So now the investment is now worth $9,000. If she sells all her shares worth $9,000, her cost basis remains the same at $5,000. So she'd have a $4,000 long-term gain in addition to the $1,000 distribution. In short, she'd have a $5,000 long-term gain in either scenario.)
Don't let the tail wag the dog here. Selling a fund simply to avoid a distribution is not a strategy worth pursuing, warns Dickson. Instead, investors should first decide that they want to sell their fund and then consider the timing of the sale.
Of course, with most funds in negative territory this year, many fund investors might want to unload their fund shares simply to take advantage of the tax breaks on capital losses, says CPA Ed Slott, of Rockville Centre, N.Y. If they don't need the cash and are happy with their current asset allocation, they can then invest in a fund with a similar objective, or wait 31 days to reinvest in the same fund, thus avoiding the dreaded wash sale rules.
For those looking to sell some -- but not all -- of their shares of a particular fund, some thought should be given to the method used. There are four potential strategies for selling shares. The easiest is the "average-cost method" (which is how most fund families will calculate your basis), but tax-savvy investors may benefit from using an alternative methodology.
Those unloading all of their shares may want to dollar-cost average out of their fund, says Kara Molland, an investment-planning specialist at Strong Funds. This could be wise for investors moving out of a particular asset class -- for example, someone slowly moving into cash to get ready for a looming financial deadline like a college bill. But this doesn't always make sense. Investors reaping some tax losses (by, say, selling one growth fund and immediately buying another) should probably do their sale in one fell swoop, says Morningstar's Cooley. And dollar-cost averaging might not make sense with exchange-traded funds (or any fund you buy through a broker), since you'll incur a trading cost each time you sell.
Finally, for investors who reinvested their dividends during previous years, don't forget that taxes have already been paid on these distributions. They should be added to your cost basis so they aren't taxed twice. This information should be included in the year-end statements sent to you by your fund company. For more on this, see our previous story.
Still interested in selling before the distribution? Many fund families have posted distribution estimates on their Web sites -- and most of them break down what the distribution will consist of (that is, long-term gains and/or short-term or income distributions). One can also obtain this information by calling the fund family's customer-service number. Should a shareholder wish to sell before the distribution, he or she needs to do so as of the "record date," which is typically the day before the distribution is made. Year-end distributions are typically made in December, although this varies by fund family.