Christmas is fast approaching and with it comes the end of another calendar year. In the mutual funds industry, the end of the year brings something I call ‘distribution season'. Distribution season refers to a time when mutual funds are cleaning out their tax accounts and investors are faced with some important issues.
Having dealt with many individual investors, mutual fund distributions can be one of the most confusing and misunderstood items in the mutual funds industry. I will try to tackle this issue as best I can.
Mutual funds distributions does not equal profits
One of the biggest misunderstandings is that many investors think mutual fund distributions are simply profits of the fund. I think this happens because many investors relate the distribution of a fund to the dividend of an individual stock. The two are very different.
Any income earned by a mutual fund is subject to tax. If the income remains in the fund, the fund will have to pay the tax. Mutual funds have to pay tax at the highest marginal tax rate so the mutual fund company prefers to distribute the tax to the investors who may pay tax at a much lower tax rate. It is in everyone's best interest to have the mutual fund pay a distribution.
As a result, the mutual fund distribution is really a function of tax more than profits. It is possible that a mutual fund will grow in value but there will be no distribution and no tax to the investor. It is also possible that a fund does not grow in value and there can be a taxable distribution to the investor. So be very careful in thinking that a distribution is the same as a profit. Remember that distributions are not an indicator of fund performance. There is NO link between the amount of the distribution and performance of that fund.
Understanding how distributions affect the price of the fund
Many investors get concerned about buying or selling a mutual fund before or after the fund makes its distribution because they think they are buying the mutual fund at a higher or lower price. Buying a mutual fund before or after a distribution can make a difference in the amount of tax that you pay, but it will not affect the performance of your fund. This is best illustrated through an example:
Let's say you own 100 units of a mutual fund and the price is $10 per unit. That means you have $1000 in total. Let us further assume the mutual fund is issuing a distribution of 50 cents per unit. Some investors might think that they should buy the fund before the distribution so they can make the extra 50 cents per share. What actually happens after the distribution, is the unit price of the fund drops from $10 per unit to $9.50 per unit you have 100 units, then you will have a distribution of $50.
If the distribution is reinvested, then the $50 will buy 5.263 units at $9.50 per unit. In total, you will have 105.263 units at $9.50, which remains a total of $1000.
If the distribution were paid to you in cash, then you would have 100 units at $9.50 per unit, which totals $950. This makes sense given that you were paid $50 in distributions.
RRSP or TFSA versus non-RRSP purchases
If you are buying a mutual fund in a Registered Retirement Savings Plan (RRSP) or Tax Free Savings Account (TFSA), then you do not really have to pay much attention to mutual fund distributions because the RRSP defers any investment income as long as the funds remain registered. All investment income in a TFSA is tax free.
However, if you are purchasing mutual funds outside the RRSP or TFSA, it is very important to be aware of the potential for mutual fund distributions. At this time of the year, if you buy a mutual fund outside the RRSP or TFSA prior to the distribution, you will have to pay tax on that distribution even though you did not own the mutual fund for the entire year.
Not all funds will have big distributions at the end of the year so make sure you know ahead of time whether the mutual funds you want to buy are going to issue distributions. You may be better off just waiting until after the distributions before you buy.
My two cents
Mutual fund distributions can be very complicated and confusing. My main point is to make sure that you do not associate distributions with performance. They are not the same. It is very hard to try to explain distributions in 700 words or less so I encourage you to speak to your financial advisor for further clarification.