During the past few months, clients who hold mutual funds in non-tax sheltered accounts likely received distributions from those funds in the form of interest, dividends or capital gains.
Often those payouts are immediately and automatically reinvested in the purchase of more shares of the same fund. But, by doing so it could cost your clients money and create big headaches for them and you, now and in the future.
Here is why you and your clients should reconsider whether they should reinvest those mutual fund distributions at all.
A Taxing Situation
There are several scenarios in which reinvesting mutual fund distributions can create tax problems for clients if the funds are not held in tax-sheltered accounts.
The first scenario might come in the next few weeks, when clients who had payouts reinvested during 2018 get 1099-DIV statements from the Internal Revenue Service, stating that those distributions are taxable.
Don’t be surprised when some of your otherwise knowledgeable clients think that since those distributions were reinvested, they don’t owe taxes on the payouts “because we didn’t take the money!”
A more covertly negative situation can happen when a client sells fund shares to realize a loss, but in the meantime has automatically reinvested distributions in the fund within a time frame that violates the IRS “wash sale” rule. If the client buys shares, whether via reinvestment or an outright purchase in the fund within a window that begins 30 days before and ends 30 days after the date of the loss sale, the client’s deductible loss is reduced by the amount of the purchases made within the window.
From Nuisance to Nightmare
Woe be unto the client who has owned a mutual fund in a non-tax account for many years (or worse yet, decades) and has dutifully reinvested the distributions over that long period of time. Eventually, when the client may need to sell those shares, whether to cover spending needs or to re-allocate the asset mix by reducing the exposure to that fund, a sale of some or all of the shares means the client has to report the sales proceeds and cost basis on the ensuing income tax returns.
Unless the client is selling shares that were purchased in the last few years, this situation can trigger an aggravating series of phone calls to the fund company and send the client digging through boxes in the basement in search of old statements to try to come up with the actual purchase dates and prices. If the client can’t find the correct cost basis information, the IRS may deem that the cost basis is zero and the entire sales proceeds could be taxable.
What could be even worse is when the client sells just a portion of the mutual fund position and has to choose from several cost basis reporting procedures, and then remember which strategy was used (and perhaps which shares were and weren’t sold) until the entire position is liquidated.
Buying at the “Top”?
Whether the account is tax-sheltered or not, another danger of reinvesting mutual fund distributions is that the client may end up investing more money when prices are high and less when prices are low.
According to the 2018 Investment Company Fact Book, mutual funds paid out $512 billion in dividends and capital gains during the stock market peak year of 2000. That figure fell dramatically to $130 billion in 2002, when stock indexes reached cyclical lows. In the heady year of 2007, mutual funds distributed $690 billion in dividends and capital gains, but in 2009, during the wake of the financial crisis and precipitous asset price declines, the figure dropped over 70 percent, down to $202 billion. Causation certainly doesn’t equal correlation, but these figures show that mutual funds usually distribute more in dividends and especially capital gains after good years, rather than bad years.
Allocation Imbalance
Even if you and the client are comfortable with more money going back into a fund near a cyclical peak, reinvesting a particular fund’s distributions right back into the same fund may push its portion of the portfolio past the preferences of you and your client. As mentioned earlier, selling some of a fund’s shares to realign the allocation can trigger a load of tax and bookkeeping hassles. But if the fund’s distributions are already being taken by the client in cash, it’s much easier to redeploy the money in the optimal investment or send it out for spending.
When Reinvesting Might Be Right
Despite the potential hassles of reinvested distributions, there are still a few instances in which you and your clients may want to start or continue the practice.
First, tax-sheltered vehicles like IRAs and Roth IRAs require no tax reporting while the investments are within the accounts, so the reinvestments will not create any tax issues now or in the future.
Second, if you’re using “A” share class mutual funds that allow the client to reinvest distributions with no new sales charge, it’s likely in the client’s best interest to do so.
Avoiding Future Problems
There are several steps you can take going forward to minimize the pain you and your clients experience from reinvesting mutual fund distributions. Start by reviewing the clients’ current holdings in taxable accounts, and when appropriate and after discussing it with the clients, remove the automatic investment of dividends and capital gains in their current accounts.
Make sure any new purchases of mutual funds in non-tax sheltered accounts have the same “cash” designation for distributions. Finally, consider a campaign to make sure every mutual fund held in a client’s non-tax account has the correct cost basis and purchase date information in your system. Getting the numbers right will not only help you analyze if and when to sell the shares for maximum tax efficiency, but also help you and your client avoid scrambling for the data at the end of the year, or on April 15.