Buy index fund before or after dividend declaration?

[Amethyst]

I have some gains from a mutual fund which I decided not to reinvest in that fund. Instead, I'd like to invest the gains into VTSAX, but I'm not sure whether to do that now, or wait until VTSAX has declared its dividend on 20 December. Funds are cheaper right after the dividend, correct?

Amethyst

 

[pb4uski]

I would wait. Otherwise 16 cents per share of what you buy would be returned to you as dividends.

See https://personal.vanguard.com/us/insights/article/estimated-yearend-distributions-12092013

 

[NW-Bound]

Regarding fund share price before/after a dividend payout, it is a wash.

Let's say a fund is $10/share before dividend payout. At the close of the dividend day, it pays out $1/share in dividends, cap gains, etc... The next day, it's worth $9. So, it's all the same.

Well, sort of. When you consider tax ramifications, it's better to wait until after dividend payout if you are going to buy for a taxable account. In the example above, immediately after you send in $10 to the MF, the next day you will get $1 kicked back to you as dividend, which you may have to pay taxes on whether you take it in cash or reinvest it. You will still have your $10, but suddenly $1 of that becomes "income" which may be taxable. It's called "buying a dividend" and is to be avoided. If buying for an IRA, then it does not matter.

This 2013 is a good year and many of my MFs have declared and paid good cap gains and dividends. So, watch out for taxable "instant incomes" if you are buying for your after-tax accounts.

 

[NW-Bound]

I should note here that the tax that you would pay on the "instant dividend" would be recaptured if and when you sell the share, so it is not quite unfair.

Let's say you decide to sell the MF immediately after the dividend payout. You will get only $9 for it, while you paid $10. So, you will be able to claim $1 "instant" capital loss, which cancels out your $1 "instant" dividend.

Of course, people would hold the shares for a while, and the tax advantage of the higher basis of $10 vs. $9 will carry into the future when they finally sell.

 

[pb4uski]

I would wait. Otherwise 16 cents per share of what you buy would be returned to you as dividends.

See https://personal.vanguard.com/us/insights/article/estimated-yearend-distributions-12092013

NWB raised a good point. My comment assumed taxable account. If tax-deferred or tax-free it would not matter.

 

[Amethyst]

It is a taxable account.

A.

 

[bUU]

The rule of thumb I've heard is, "Don't buy the dividend."

 

[Amethyst]

Me too...I often consult ER Forum for real-live takes on "rules of thumb."

The rule of thumb I've heard is, "Don't buy the dividend."

 

[karluk]

The rule of thumb I've heard is, "Don't buy the dividend."

I've heard that rule of thumb too. In fact I've heard it many times from many sources. After working through the likely scenarios, I've convinced myself that this rule of thumb is virtually always wrong, at least for my family's tax situation. If you own a fund that consistently produces 100% qualified dividends and are in the 15% tax bracket, it's either a wash or you end up ahead by buying the dividend.

scenario 1. buy the dividend, pay $0 additional tax now, share price increases in the future. You can then hold your shares until your gains become long term, sell them at the 0% capital gains tax rate and pay no tax at all on your investment. This will usually be a wash compared with not buying the dividend, but you are ahead in the sense of having an increased cost basis, which protects you from both tax law changes and increases in family income that might make your capital gains get taxed at more than 0% in the future.

scenario 2. buy the dividend, pay $0 additional tax now, share price decreases in the future. You can then sell your shares at a loss in the following tax year. Your loss can be subtracted from ordinary income (up to $3,000) from the following year's tax returns. The fact that you have a higher cost basis than if you hadn't bought the dividend means that you have a larger loss and hence a larger subtraction from ordinary income. You come out ahead compared with not buying the dividend.

The lesson here is to do your own math and not rely on rules of thumb that frequently are inapplicable, or just flat out wrong, when applied to your own tax situation.

 

[ziggy29]

I've heard that rule of thumb too. In fact I've heard it many times from many sources. After working through the likely scenarios, I've convinced myself that this rule of thumb is virtually always wrong, at least for my family's tax situation. If you own a fund that consistently produces 100% qualified dividends and are in the 15% tax bracket, it's either a wash or you end up ahead by buying the dividend.

Of course, there's another rule of thumb in play, too: Don't pay a tax today that you can defer into tomorrow.

That said, THAT one can be wrong, too: for example, stock dividends and capital gains in a taxable account will have (under current law) have a lower tax rate but if held in an IRA the gain from dividends and LTCG is taxed as ordinary income when withdrawn from the IRA. The moral of the story? Rules of thumb are just that -- not ironclad, exception-free maxims.