Why do most mutual funds make year-end distributions in December

As year-end approaches, you may see financial news stories suggesting investors can be wary of making new investments in mutual funds with upcoming year-end distributions. Here, we'll cover why that may be good advice-and why mutual funds make year-end distributions in the first place.

Most mutual funds make annual distributions in December to satisfy excise tax requirements. There are two sources of potential distributions: earnings and capital gains. If a mutual fund under-distributes either type, the fund faces a 4% excise tax on the portion under-distributed. If applied, this payment is shared across all shareholders.

Managers and their mutual fund service providers work hard to avoid those excise taxes. The rules are slightly different for income and capital-gains distributions:

• Income distributions are paid on a calendar-year basis. This means the manager (or typically its third-party fund administrator) must estimate any dividends or other payments to be received late in the year. Managers must distribute at least 98% of any net income earned during the year.
• Capital-gains distributions are calculated on a slightly different schedule. Rather than the calendar year, they are reviewed from November 1 (of the prior year) through October 31 of the current year. Managers must distribute at least 98.2% of net short-term and net long-term capital gains during this period.

Again, if the fund fails to make these annual distributions, all shareholders will share a 4% excise tax on the under-reported value. Therefore, fund administrators have careful processes in place to make estimates. These processes revolve around three key dates:

• Record date - the shareholders who own the fund on this date will receive the distributions
• Ex-date - the date that the distribution will come out of the fund's net asset value (NAV)
• Payable date - the date that the cash or shares will appear in shareholders' accounts

For example, in estimating income, fund administrators look at the holdings of the fund to determine if there will be any dividends or other payments made between the ex-date and the end of the year. They do the same thing for expenses. The more complicated the fund investments, the more difficult the estimating. For example, any fund that owns another fund must estimate the amount of income or capital gains the underlying fund will earn or pay.

Another complicating factor is wash sales. In calculating capital gains, fund administrators look for situations in which a fund sells a security for a loss, then buys it back within a 30-day period. When a wash sale occurs, the capital loss (which would otherwise be netted against capital gains) is deferred until the repurchased shares are sold.

Impact on NAV-and on investors

When distributions are made, assets that had previously been held by the fund are distributed to the investors. This creates a taxable event for shareholders (unless they hold the fund in a retirement or other tax-deferred account). Early in the following year, the shareholder will receive a 1099 tax statement showing the distributions. Shareholders then need to include these distributions (as income or capital gains, as the case may be) on their tax returns. That's true even if shareholders elected to reinvest the distributions (that is, not receive actual cash payments from the fund).

Since assets are leaving the fund, the NAV of the fund will fall when distributions are made-or, more precisely, on the ex-date. (This assumes no other market activity impacts the fund's NAV at that same time).

Here's where things can be unpleasant for new investors in a fund. Say you are a new shareholder who made an investment on or just prior to the record date. This means you will receive a distribution proportionate to your ownership of the fund on the record date. But you have not had any time to see the value of your investment go up-and now taxes are due on the distribution.

Mutual fund annual distribution scenarios

Let's review two examples-first, of someone who invested in a hypothetical fund on January 1, and second, someone who invested on or just prior to the record date of December 30.

Investor A

• Purchased a fund on 1/1/XX at $10
• During the year, the fund earned $1 in income and capital gains. NAV at the end of the year is $11.
• Fund pays $1 in distributions to shareholder. NAV drops back to $10.
• Investor receives cash or additional shares for the $1 and will receive a 1099 to include on their taxes.

Investor B

• Purchased a fund on 12/29/XX at $11
• Fund pays $1 in distributions to shareholder. NAV drops to $10.
• Investor receives cash or additional shares for the $1 and will receive a 1099 to include on their taxes.
• Investor is showing a $1 unrealized loss that will not be able to offset the income received until the investor sells the fund.

As summarized here, Investor B will owe taxes on the distribution (even if reinvested) and will also experience a capital gains loss that cannot be netted against taxes owed-at least until the investor sells the fund, which may be many months or years in the future.

Distributions are described in shareholder communications sent to brokers, the transfer agent, and often other media sources that will report the information. Often, fund websites will show estimates and final information as it becomes available. Fund managers and service providers recognize that annual distribution impacts can be significant for shareholders and so seek to process them in a careful, timely fashion that avoids excise taxes.

Learn more about UMB Fund Services and how we can support your firm's registered and alternative investment fund administration needs, or contact us to be connected with a fund services team member.

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