Mutual funds buy and sell stock and other securities throughout the year. Gains on these sales increase the "net asset value," or NAV, of the fund, and your shares in the fund increase in value.
Federal law requires that funds distribute net capital gains each year to shareholders. During the fourth quarter the fund manager will calculate the net gains for the year, declare a capital gain dividend, and distribute this dividend to shareholders. This is usually done in mid to late December. The shareholder will pay federal and state income tax on this distribution. After the distribution is made the NAV of the fund will drop.
Basically, if your shares are worth $10,000 on December 1st and the fund issues a $1,000 capital gain distribution on December 15th your shares will be worth $9,000 on December 16th. If you had purchased the shares on December 1st you would be stuck with paying tax on $1,000 without actually receiving a financial benefit from the $1,000. You started out with $10,000 but end up with $9,800 or so ($9,000 NAV plus $1,000 dividend received less federal and state income tax on $1,000 dividend).
If you want to purchase shares in a mutual fund during the fourth quarter of the year, wait until after the capital gain dividend has been issued, and the NAV has dropped, before purchasing the shares.
I am now off to the National Association of Tax Professionals’ annual year-end “Famous 1040 Workshop”. I will let you know if I learn anything of interest.
PS – Click the links below to read my series on Year-End Tax Planning: