Brace yourself for the usual year-end chorus of warnings against buying into mutual funds just before they make their year-end capital-gains distributions. And ignore the warnings.
Funds are required by law to distribute their gains. If you waited until now to buy a fund outside of a tax-deferred account, goes the rap, you'll be stuck with a tax bill on the distribution, but you won't have benefited from the fund's previous appreciation.Tune out the refrain. It doesn't always make sense to avoid a fund just because of pending capital-gains distributions, which are usually modest in size. In 1998 the average distribution for a diversified U.S. stock fund was 6.2 percent of net asset value (NAV), according to Morningstar. (You can call stock-fund sponsors late in the year to get a sense of the size and timing of distributions.)
Even more important, the typical warnings against "buying the dividend" ignore the fact that a distribution raises your tax basis by the amount of the payout, assuming that you reinvest the money in the fund.
Let's say you invest $1,000 in a fund late in the year, and it subsequently pays a capital-gains distribution equal to 10 percent of NAV, or $100. You will then owe $20 in capital-gains taxes on your next tax return.
But if your investment has appreciated to $1,100 by the time you sell your shares, you won't owe any tax on the sale because your basis will have risen to $1,100 -- the amount you invested originally plus the distribution you reinvested.
Moreover, for the past half-century, December has typically been the stock market's best-performing month. So what looks on the surface to be a smart tax move may cause you to miss out on gains that might have more than offset your tax bill.
Late last year, for instance, the popular Janus Enterprise fund paid a capital-gains distribution equal to 10.6 percent of NAV, one-fifth of which would have gone to Uncle Sam in capital-gains taxes. However, the fund jumped in value by 8.6 percent from Nov. 30 through Dec. 24, the last date before the dividend was declared -- a gain you would have missed out on if you had waited for the fund to make its payout.
The bottom line: Go ahead and take the dividend, and pay your taxes next April. You'll come out ahead.