Bonds and Interest Rates

There is a lot of stuff on the internet that deals with understanding bonds…many of them are either too technical OR too simple. How do I know this? I know because reading just one leads to a lot of unanswered questions and doubts. So, I decided to see if I can simplify them to a level where one can understand with just a single read. This level of over simplification will put me on top of the murder list for most financial experts, but please bear with me and let me know if I am egregiously wrong in any of the simplifications and I will correct them.

That said, it is time to learn some bond terminologies.

Bond Terminologies

Let us discuss a few of the terms you will find in almost all articles on bonds in the internet.

Types of bonds (lowest risk and hence lowest reward first)

  • Treasury bills or T-bills
  • Government bonds
  • Corporate bonds
  • High Yield bonds
  • Emerging market bonds

Bond Parameters

  • Purchase price
    • Price paid to buy the bond 🙂
  • Coupon or Interest
    • The periodic (yearly, half yearly, etc) interest payments paid to the bond holder
  • Yield
    • A fancy term used to describe the return provided by a fixed income investment like a bond
    • Yield = Coupon(Interest) / Purchase price of the bond
  • Maturity
    • After what time period will the bond principal be returned back to the investor (me).
    • When I buy a bond, I am loaning the bond purchase price amount to somebody (us govt, municipality, company)
    • For the duration of the maturity period (say 10 year bond), I get periodic coupon/interest payments.
    • At the maturity date, I get money I loaned out back.

Example:

  • Lets say that purchase price of bond X is $1000.
  • The  guaranteed Coupon or Interest is say $60 per year
  • The yield will then be $60/$1000 = 6%
  • Bond X has a yield of 6% earning $60 interest/coupon per year.

Bond Rating

We talked about Bond X in the previous example. We said that the guaranteed coupon/interest is $20 per year. The only exception to the guarantee is if the bond issuer defaults on the payment. For example, some bond issuers in Detroit have defaulted on the bond interest payments and declared bankruptcy. To gauge the credit worthiness of a bond, there are some rating agencies (big ones are Standard and Poor’s, Moody’s, Fitch ratings)  that classify different bonds into the following rating bands:

  • AAA: Prime
  • AA  : High Grade
  • A    : Upper medium Grade
  • BAA: Lower medium Grade
  • BA  : Non-investment grade speculative
  • B    : Highly speculative
  • CAA: Substantial risks/Extremely speculative
  • CA  : Default imminent with little prospect of recovery
  • C    : In Default
  • D    : In Default

Obviously, AAA is the best and D is the worst in the scale above.

Interest rates increases and effects on Bonds

Many many articles on the net talk about this statement “Interest rates and bond prices have an inverse relationship. When interest rates fall, bond prices usually rise and when interest rates rise, bond prices usually fall.”. What the hell does this mean? Let us take some examples and see what it means to a non-financial person.

Let us take the story of two bonds: Bond X and Bond Y.

Bond X

  • AAA rated, 6% yield, purchase price=$1000, 10 yr maturity
  • yield = coupon/purchase price => coupon/interest = yield * purchase price = 6% * 1000 => $60

Bond Y

  • AAA rated, 7% yield (interest rates increased by 1%), purchase price is still $1000, 10 yr maturity
  • coupon = 7% * 1000 => $70.

So, we have two bonds, with the same rating and purchase price, offering different yields. Bond Y will pay $70 dollars every year for 10 yrs but Bond X will pay $10 less for the same 10 years. So, why would anybody buy Bond X? This is the reason why Bond X’s value will fall when interest rates rise as there is a newer bond that offers more interest/coupon money for the same purchase price.

Let us take this one step further.

  • The total return for Bond Y is: 10 years * $70 per year => $700
  • The total return for Bond X is 10 years * $60 per year => $600
  • For Bond X to compete with Bond Y, Bond X should also somehow lead to an equal return for the purchaser i.e. the $100 difference has to be made up somehow.
  • But, the coupon/interest for Bond X is fixed at $60 per year…so, the only other way to make up the $100 difference is to reduce the purchase price from $1000 to $900.
  • So, Bond X is now sold like below:
    • AAA rated, purchase price=$900, 10 yr maturity
    • yield = coupon/purchase price = 60/900 = 6.66% yield (up from 6%)
  • A rising yield is hence bad news for any bond as it  usually means that the bond price has been lowered forcefully.
    • I.e. if I had bought Bond X for $1000 and I am forced to sell it for some reason when the interest rate has risen by 1%, I am going to lose $100 for each bond that I bought at $1000.

Interest rates decreases and effects on Bonds

The opposite  happens when interest rate decreases….the older bonds provide higher interest rates than the newer bonds and hence they become more valuable i.e. their yield increases.

Let us take this one step further.

  • The total return for Bond A (older) is: 10 years * $70 per year => $700
  • The total return for Bond B (newer, 1% lower interest rate now) is 10 years * $60 per year => $600
  • Bond A offers a better deal than Bond B by about $100. So, when all we can get today (with a 1% reduced interest rate) is Bond B, Bond A will command a premium i.e. the purchase price for Bond A becomes $1100 instead of $1000.
  • So, Bond A is now sold like below:
    • AAA rated, purchase price=$1100, 10 yr maturity
    • yield = coupon/purchase price = 70/1100 = 6.36% yield (down from 7%)
  • A falling yield is hence good news for any bond as it  usually means that the bond price has been increased by falling interest rates.
    • I.e. if I had bought Bond A for $1000 and I am forced to sell it for some reason when the interest rate has dropped by 1%, I am going to gain $100 for each bond that I bought at $1000.

Important Note

Whether interest rates are falling OR raising, when it comes to individual bonds, the bond purchase price (i.e. the principal) is guaranteed to be returned to the bond purchaser if the bond is not sold until the maturity date.

Next

If we have understood the above basics, the next challenge is to understand what happens to Bond Funds w.r.t. interest rate changes. Note that the impact on Bond funds are different than just Bonds.

Bucket Approach to Retirement

There is a common question among those planning/approaching retirement and definitely among those already in retirement.

That question is:

  • How to withdraw money from the retirement funds?
  • How to invest the remaining money while in retirement?
  • How much to withdraw each year?
  • How to not not be too conservative and run out of money?

A recent article I read from Christine Benz (Morning Star, published around 2012) was very informative to me. I am enclosing a link to that article here.

2014 Financial Independence Progress Summary

We have reached the end of year 2014 and it is time to look back at some important dates in my humble journey towards Financial Independence.

  • 01/2014
    • Hired a financial planner and got a gut check of where our finances stand
  • 03/2014
    • Tracked my budget for two months
    • Found most of the expenses I had missed in the original budget
  • 04/2014
    • Started my first investments in Vanguard
  • 07/2014
    • Started tracking my progress via this blog
  • 12/2014
    • Wrapping up my first year end of my humble journey to financial independence.

It is very humbling to see where I have come in my first year of the financial independence journey. Admittedly, I did not start with nothing or even negative worth like so many of the bloggers, but I was equally if not more “financially lost” than most of the financial independence bloggers out there.

From when I started tracking my progress (07/2014) to this date (12/2014), what have I achieved? The table below should summarize the progress from 04/2014 to 12/2014 i.e. across 8 months.

04/2014 to 12/2014
Emergency Fund ($72K) 100% 100%
College Fund (80K) 0.00% 31.04%
Passive Income Streams ($4000 pm) 0% 7.36%
Retirement Fund ($900K) 46% 53.91%
Roof for our Family ($1 mil) 0% 0%
Medical Fund 0% 0%
Life Insurance 0% 100% (term life insurance)

I am most proud of having started the Passive Income streams after having studied many of the blogs written by wonderful people like Dividend Mantra, Mr. Money Mustache, Mad Fientist, Financially Integrated, Financial Samurai, Afford Anything, Project 3 million, $25000 Dividends….uff….the list is too long to list. Thanks to all of the people who blog and share their wisdom. And thanks to Vanguard for making the process very easy to learn and start.

What is Tax Efficient Investing?

Before we talk about tax efficient investing, lets talk about the two different types of accounts: Tax-advantaged and Taxable accounts.

Tax-Advantaged Accounts

Examples of this type of accounts are 401K and IRA accounts. I do not have to pay taxes when I file taxes every year for any gains produced by investments in these accounts. The gains can be via capital gains, dividend distributions, interest, etc. The gains can grow in a tax-free environment  until money is withdrawn from these accounts. At that time, taxes will need to be paid based on the tax bracket one is at that time.

Taxable Accounts

Any account that is not tax-advantaged is a Taxable account. For example, my bank account with cash that produces interest is a taxable account because I will have to pay taxes on the interest money reported by the bank. Likewise, my Vanguard investment accounts, using post-tax money from my bank account, are taxable as well i.e. any dividends and/or capital gain distributions are taxable as well.

Tax-Efficient Investing

Gains produced in taxable accounts will be taxed according to the tax bracket one is in. Lets take an example. Consider the fund VDIGX…a dividend growth fund from Vanguard. The expected distributions for this fund for the  year 2014 are as follows:

Dividend Growth Fund    VDIGX

  • Dividends: $0.17
  • Short Term: $0.07
  • Long Term: $0.25

Each of the different category of gains are taxed at different levels depending on the investor’s tax bracket

  • Short term gains taxed at investor’s tax bracket (say 33%)
  • Long term gains taxed at 20% (fixed)
  • Dividends (qualified 100%) taxed at 15% (for folks in 33% tax bracket)

Tax-efficient investing is choosing investments in such a way that the taxes paid on the gains is minimized as much as possible. In the above example, it would be most tax-efficient if all of the gain comes in the form of dividends which are the least taxed category at 15%.

Consider another example of VCAIX….a California MUNI fund from Vanguard as well. This fund invests in MUNI bonds within California. The special treatment given to such bonds is that the gains form such bonds are both Federal and State Tax free and in most cases AMT free as well. For now, lets ignore AMT free…I will talk about this in another post. Now consider the gains produced by VCAIX for the calendar year 2014.

CA Intermediate-Term Tax-Exempt VCAIX

  • Dividends: $0.02
  • Short term: $0
  • Long Term: $0

For a resident of California, all the gains produced by VCAIX are completely *tax-free* i.e. both federal and state tax free. If not a resident of California, then it is only Federal tax free and state taxes have to be paid. So, in comparison to VDIGX,  for a resident of California, VCAIX isdefinitely more tax efficient than VDIGX.

So, tax-efficient investing is not about NOT_PAYING_TAXES. It is about MINIMIZING-TAXES-PAID and hence maximizing the gain that the mutual fund delivers.

NOTE:

  • VCAIX offers an appx gain of say 3%.But, being tax free means I get to keep the 3% completely.
  • For a taxable (or a less tax-efficient) fund to allow me to keep 3% post taxes, the fund has to produce a gain much higher than 3% to compensate for the taxes that need to be paid.
  • There is a calculator called Taxable Equivalent Yield Calculator (link below) where if I put in 3% and 33% as my tax bracket, I get the result of 4.48%. So, before paying taxes, the fund has to provide a gain of 4.48% so that post tax, I get to keep 3%.
  • For a portion of my portfolio, I may decide to take less risk and go for VCAIX at 3% vs taking more risk and investing in another fund that produces 4.48% gain. Now you see the power of tax efficiency 🙂
  • Of course, I do not want all my investments to be in VCAIX right…it is not diversified enough. So, asset allocation should still be higher priority than tax-efficient placement. Another post for this later….but for now, read the first link in the reference links below.

Reference Links

How I selected my life insurance coverage…

I defined what Financial Independence means to me here. One of the pillars of my financial independence is Life Insurance. In this post, I will talk about how I went about choosing life insurance coverage for my family.

General Principles for choosing Life  Insurance

There are few questions to answer when it comes to life insurance. Let us take each one and expand on it. After that, we can talk about the choices I made and why.

  • Yearly family budget
  • Term life or whole life
  • Policy Term
  • Policy value
  • Which life insurance company
  • What age to buy it at

Yearly Family Budget

The first step in planning for life  insurance is knowing what the yearly budget is going to be. There are many free budgeting tools available online and many financial planners as well. It is well worth the effort and/or the cost to come up with a solid expense budget. Make sure to include future expenses as well. For example, I do not have a house yet…we rent at $2500 pm. In future, when I get a mortgage, I anticipate the mortgage cost to jump to $4500. So, use $4500 as part of the budget. Likewise, if you plan to extend the family in future, scale  up the cost by the number of kinds you plan to have OR number of people you need to support. Run with this budget for a month OR two and see how accurate the budget is. It will take 1-3 months to iron out all the kinks….but if you are off by $1000 for the whole year, no big deal; if you missed a $20000 expense, it can prove painful. Once you have a yearly budget done, move onto the next step.

Term or Whole life insurance

There are two main types of life insurance: term life and whole life.

  • Term life is for a fixed time interval…say 20yrs for example. If I buy a 20 yr policy && die within the 20 yrs, then the policy amount will be paid to my family. If I do not die during the 20 years, then I get *zero* dollars on policy maturity. I.e. term life insurance is a bottom less pit, a black hole, etc etc. The advantage is that it tends to be cheaper than whole life insurance.
    • There are options that can be added to term life insurance policies that can convert the term life policy into a while life policy when the term life reaches maturity. These options are called Riders, which cost a yearly premium. For example, a 20 yr term life with a rider to convert it to a whole life costs an additional $200 per year. NOTE that this $200 per year is just to have the rider. To convert it to whole life, some additional premium will need to be paid…the rider only gives the opportunity to pay the premium to convert to whole life i.e. the conversion is not free.
  • Whole life insurance is for the entire life of the insured. Whole life policies build cash value by way of premiums and dividends. Values for death benefits and premiums are usually determined at policy issue, for the life of the contract, and usually cannot be altered after issue. Since the person may live well into the nineties, the risk of payout carried by the Insurance company is higher too. So, whole life insurance tends to be an expensive proposition.
    • In the first few years of mortgage payment, the payment mainly feeds the interest and the principal does not reduce much. Just like that, the insurance agent gets a lot of the commissions in the first few years of the whole life policy and the policy itself does not build value.

Policy Term

If whole life is chosen, then this question does not arise. If term life is chosen, then what should be the policy term chosen? The idea I liked was to protect the family from any emergencies for the earning years of the primary income earner in the family. Usually, it is until 65 years of age.

Policy value

The idea I liked was this. When the primary income earner dies suddenly, the remaining spouse will be in no shape to start working OR continue working as the case may be. So, life insurance should provide sufficient buffer to replace the yearly budget for a sufficient number of years. I.e. if the yearly budget is $100K, then providing 10yrs of income replacement will mean a $1million policy.

Which life insurance company

Life insurance is offered by many companies….Guardian, Mass Mutual, Northwestern, Fidelity, etc etc etc….The company I chose to protect my family for the next 30 years should itself be able to survive for the next 30 years. There is no guarantee that past performance will lead to future performance as well. But, I went about collecting the ratings of all insurance companies from rating agencies like S&P, Fitch Ratings, AM Best, etc. The top ones came out to be the following:

  • Guardian and Mass Mutual (equal)
  • Metlife
  • NorthWestern Mutual
  • Prudential

What age to buy it at

Earlier the better 🙂 I say this because usually one’s health is much better in 20s than in the 40s. The insurance is much cheaper when one is younger and healthier. So, better to buy as early as possible…when there are people who start depending on your salary.

My design principles in choosing Life Insurance

The design principles I used were

  1. Protect my earning years
  2. Reasonable and fixed monthly cost
  3. Stable Life Insurance company

Protect my earning years

When I starting thinking about Life Insurance, I wanted to protect my family from any emergencies for my earning years i.e. until 65-70 years of age. I may achieve financial independence earlier than that..if so, the life insurance will be a luxury. If not, I did not want my family to suffer.

Reasonable and fixed monthly cost

I decided upon Term Life Insurance because of two reasons…it was cheaper was one reason and spreading the risk was another.

What do I mean by spreading the risk? I decided to invest the difference between term and whole life in the stock market. Historically, the growth from stock market has proved to be better than the growth of the whole life insurance. So, paying for term and investing the difference also spreads the risk….all risk on the insurance company (whole life) vs risk in the insurance company (term life) plus risk of the investments (in many companies).

So, my selection was Term Life Insurance and not Whole life with a policy term of 30 years i.e. until I am 70yrs of age. 65 would have been good, but there was no policy for that many years. By 70 yrs, I hope to have a reasonable financial plan for my family 🙂

The approval process took a long time but the policy has been approved! It costs me a packet every month…a bottomless pit…but, at least my family is covered until 70yrs of age.

Stable Life Insurance Company

Based on my ratings data collection, both Guardian and Mass Mutual were fine. I decided to go with Guardian Life Insurance…the Guardian folks were more prompt in approaching me and thus they were chosen 🙂

Conclusion

Hopefully, the above longish post has given a flavor of how to select an insurance policy and the knobs that are available for people to fine tune the choices to protect their family.

Dividend Investing: Mutual funds v/s Individual stocks

Being a lazy investor who likes periodic investments, mutual funds is the most obvious alternative for me. But, there are many people who favor investing in individual stocks that lead to dividend income. If the dividend income is the same in both cases, then which one to pick? I.e. what are the tradeoffs in each method? Here are some thoughts with an example.

Let us consider VDIGX as the example mutual fund and a dividend producing individual stocks basket. The stocks we will assume to be part of both VDIGX and the stocks basket are:

  • Wal-Mart Stores, Inc.
  • Johnson & Johnson
  • Microsoft Corporation
  • Merck & Company, Inc.
  • TJX Companies, Inc.
  • Chevron Corporation

For an investor to maintain an individual stocks basket of the above stocks, he/she has to do a financial analysis of the companies involved OR at the least, spent time studying the reports available in the internet, company’s SEC filings, etc. One also has to evaluate the price of the stock based on its earnings potential. In short, there is a reasonable amount of financial knowledge and capability needed to invest in individual stocks.And, tax time can be a pain 🙂

But, the advantages are that once you own the stocks, you (the investor) gets to decide when to sell the stocks, when to realize capital gains (short or long term), buy and hold forever OR sell at the opportune time, buy and sell instantaneously during the day, etc etc. There may OR may not be commissions involved for buying/selling depending on the stock broker platform used (etrade, vanguard, and a whole host of providers with different fees per trade).

VDIGX, on the other hand, is totally controlled by the fund manager who currently happens to be Don Kilbride, a recognized name in the industry. He decides when to sell or buy company stocks, in what quantity, which companies to buy, etc. So, there is a loss of personal control over the investment. In addition, you (the investor) has to pay Don a fee for managing the investments. Since I do not have the time nor the knowledge to do a financial analysis, I have to pay Don the fees to do the work on my behalf. Since Don has a proven track record of producing reasonable gain, I am betting that past performance is a reasonable (but not guaranteed) predictor of future performance. Due to the loss of control, you (the investor) cannot control the time of selling/buying stocks, realization of capital gains (short or long term), which companies to buy, etc. For example, Don OR some other fund investor could sell VDIGX shares and force a capital gain of the short term. In addition, if you do not invest in the fund anymore after a certain amount of money, you still have to pay Don some money.

The advantage of course, is that you (the investor) does not have to evaluate the financial stability of the company, the value of the stock, etc etc. Don has years of experience in picking such stocks and also has a well known company like Wellington/Vanguard overseeing the process of picking such stocks. And tax time is as easy as taking the 1099 form that Vanguard will send for VDIGX and filling up the form in a tax form 🙂

For the lazy investor (like me), VDIGX is perfect. For the more knowledgeable investor, picking individual stocks may be the way. Hope this article gives a flavor of the issues to be aware of in choosing mutual funds vs individual stocks.

PS: For a more detailed article on tax treatment, please read another post by HumbleFI titled Tax consequences of investing in Mutual Funds

Tax consequences of investing in Mutual Funds

One of the disadvantages of investing via mutual funds is that the tax consequences are not in my (the investor) control. What does this actually mean? I will answer this in three sub sections

  • Tax Terminologies w.r.t. Mutual Funds
  • Special Dates w.r.t. Mutual Fund Distributions
  • Tax consequences of Mutual Funds

Tax Terminologies w.r.t Mutual Funds

Mutual Fund Distribution:

  1. Mutual funds give back money to investors in two ways: through dividends and/or capital gains
  2. These money give backs are called Distributions.

Long term vs Short term Capital gains distribution

  1. When a share in the mutual fund is held for less than one year and sold, the gains it generates are called Short term capital gains
  2. When a share in the mutual fund is held for more than a year and sold, the gains it generates are called Long term capital gains
  3. Short term cap gains are taxed as ordinary income….say 33% for many people in the Silicon Valley
  4. Long term cap gains are taxed at a rate less than ordinary income….say 15%.
  5. So, getting long term cap gains from mutual funds is very tax efficient.

Dividend Distributions

  1. When a share OR a bond is held in a mutual fund, it can generate dividends and/or interest.
  2. These dividends are taxed at a rate less than ordinary income…..say 15%
  3. So, getting dividend distributions from mutual funds is very tax efficient.

Tax Exempt Mutual Funds

  1. These funds are generally exempt from federal taxes, and in some cases, exempt from state taxed also depending on residence requirements.
  2. Example: Municipal bond fund VCAIX (California MUNIs)  is both federal and state tax free because I am a resident of California.
  3. I.e. distributions from tax-exempt funds like VCAIX do not pay tax!!
  4. NOTE: There is a limit on how much tax-free income a person can get in one taxable year. AMT (Alternative Minimum Tax) enforces a minimum amount of tax per year i.e. makes sure that there are not too many tax deductions claimed in one taxable year.

AMT Free Mutual Funds

  1. From Vanguard. AMT is defined as: A separate tax system designed to ensure that wealthy individuals and organizations pay at least a minimum amount of federal income taxes. Certain securities used to fund private, for-profit activities are subject to the AMT.
  2. Each mutual fund can generate gains that are AMT free OR not. If a fund has no AMT exposure, it can’t trigger the AMT, no matter how much you own.
  3. Consider the following two Vanguard mutual funds
    1. Mutual Fund with Alternative Minimum Tax = 0%
    2. Mutual Fund with Alternative Minimum Tax = 16.9%
  4. If you are a California resident, the first fund is both federal and state tax free. Whether you get $1000 tax free gain OR $1000000 tax free gain, these gains will not trigger the AMT. The second is obviously not…there is a percentage of the gain that will count against the AMT limit. For example, if the AMT trigger limit is 169, getting a $1000 gain will mean $169 of it will apply towards the AMT limit and trigger it.

Form 1099-DIV

  1. This form indicates mutual fund earnings shareholders must report on their income tax returns.

Special Dates w.r.t. Mutual Fund Distributions

There are four important dates associated with a mutual fund distribution. This is because a mutual fund goes through a two step process in making distributions.

  1. Declaration Date
    1. On this date, the board of directors (for individual stocks) OR the mutual fund company/manager announce to the whole world that the individual stock OR the mutual fund will pay a dividend.
    2. This date has no bearing on your taxes.
  2. Ex-dividend Date
    1. First, the fund “declares” the amount of distribution it intends to make and sets aside the necessary amount of cash to match the intended distribution.
    2. Setting aside cash has the effect of lowering the NAV (net asset value) of the fund by the amount of cash that has been “taken out” of the fund for distribution purposes. Note that no cash payment is made to the fund owners at this step….cash is only set aside.
    3. This date that has the most bearing on your taxes.
      1. If you buy a dividend paying stock (or mutual fund share) one day before the ex-dividend date, you will still get the dividend. If you buy on the ex-dividend date, you won’t get the dividend.See Record date section next for more details.
      2. If you want to sell a stock (or mutual fund share) and still receive a dividend that has been declared, you need to sell on (or after) the ex-dividend day.
    4. The ex-date is the second business day before the record date.
  3. Record Date
    1. This is the date on which the company looks at its records to see who the shareholders of the company are.
    2. An investor must be listed as a record holder (of the stock or fund shares) to ensure the right of a dividend payout.
    3. The ex-dividend date is usually 2 days before the Record date. And it takes 3 days to record an investor as a record holder. So, to be on the “books” on record date, the stock and/or fund purchase has to happen a day before the ex-dividend date. Purchasing on the ex-dividend date will not lead to the purchaser being on the record books and hence will not be a dividend target.
  4. Payment Date
    1. On this date, the fund actually pays the mutual fund share owners real money from the cash pool that is set aside on the ex-dividend date.
    2. This date has no bearing on your taxes

Tax Consequences of Mutual Funds

One of the main disadvantages of investing via mutual funds is that the tax consequences are not in my (the investor) control. What does this mean? Lets see…

  1. From the previous section, we saw that Mutual funds can distribute two types of taxable gain to shareholders: ordinary dividends and capital gains distributions.
  2. Let us say that I purchase shares of a mutual fund at $10 per share and the share prices rises to $100. Now, if I sell the 10 shares, there can be a taxable gain for the mutual fund because of the increased share price. This taxable gain will be distributed to all the mutual fund shareholders..in proportion to the number of shares that they own. Lets say that this year, I do not have money to pay taxes for the gain. So, I decide to not sell my shares this year.
  3. But, if the mutual fund manager sells shares of one of the components of the mutual fund to re-balance it and there is a profit on the shares, then the mutual fund will distribute the gain to all the share holders.
  4. This will lead to a gain for me for this year when I do not have the money to pay taxes for it. In the worst case, I may be forced to sell some shares to pay the tax to the government. This is what I meant by saying that the tax consequences are not in my (investor) control.

The other main disadvantage is the timing of the taxes paid. What does this mean?

Assumptions:

  • New calendar start date: Jan 1
  • Ex-date is Dec15th
  • Record date is Dec 17th
  • Payment date is Dec 20th.
  • Tax year ends on Dec 31st

Scenario 1:

  • Assume that Investor A bought 100 shares of a fund for $10 a share on Jan 1st. The shares rose in value to $20 on May 1st. Investor A then sells her shares on May 1st, and owes taxes on $1,000—the capital gain of $10 a share ($20-$10) times 100 shares.NOTE that this tax will be due when taxes are filed in the next calendar year (April 15th of next year is the tax deadline).
  • Investor B buys 100 shares at the fund’s new NAV of $20 a share on May 1st, which includes the embedded gains ($20-$10). The shares rise to $30 a share on Dec 1st, and Investor B sells his shares. Investor B would owe taxes on $1,000—the capital gain of $10 a share ($30-$20), times 100 shares.NOTE that this tax will be due when taxes are filed in the next calendar year (April 15th of next year is the tax deadline).
  • In other words, Investor A owes taxes on the $10 gain accrued while she owned the fund (Jan 1st to May 1st), and Investor B owes taxes on the $10 gain accrued while he is invested (May 1st to Dec 1st). Each shareholder is paying for his or her own gains earned.

Scenario 2:

  • Assume that Investor A bought 100 shares of a fund for $10 a share like in Scenario 1 i.e. Jan 1st. The shares rose in value to $20 on May 1st. Investor A then sells her shares on May 1st, and owes taxes on $1,000—the capital gain of $10 a share ($20-$10) times 100 shares. This is the same as in Scenario 1.
  • Now assume Investor B bought his shares on Dec 14th i.e. one day before the ex-dividend date. So, on record date, Investor B will qualify as a record holder. So, Investor B buys his shares at $20 on Dec 14th.
  • On ex-date, cash is set aside proportional to the distribution needed. So, the NAV falls to $10 per share, with $1000 (($20-$10) * 100) set aside as cash for distribution. On record date, it is decided that both Investor A and B are record holders and would get the dividend distribution.
  • Investor A still owes taxes on $1,000—the $10 gain on her shares, bought at $10 and sold at $20, times 100 shares.
  • Investor B bought the stock at $20 and did not realize any gain…but must now pay taxes on $1,000—the $10 per-share distribution ($20-$10), times 100 shares. I.e. it seems like Investor B is paying taxes on zero gain…is this possible? No. Read next.
  • The distribution reduces the fund’s NAV to $10. If Investor B pays the taxes from other assets and reinvests the full amount of the $1,000 distribution, he will now own 200 shares. The first 100 shares were purchased at $20 a share, while the second 100 were purchased at $10 a share. Investor B’s average cost basis for tax purposes is $15 a share.
  • Post the distribution (say May 1st of next year), lets say that the shares then rise by 50 percent, as in Scenario 1, to a new value of $15 a share.
  • When investor B sells his 200 shares at $15 a share on May 1st of next year, for tax purposes he is treated as having purchased all those shares at his average cost basis of $15 per share. Thus, he has no new tax liability because he has already paid taxes on his own gain.

Is Investor B paying taxes on zero gain?

  • Investor A paid her own taxes on the $1,000 gain when she sold shares at $20 with a cost basis of $10; she delayed paying taxes until she sold.
  • Investor B paid taxes on the $1,000 distribution up front, but owed no additional taxes when he sold his shares with the same price ($15) as his cost basis. Thus, he pays taxes only on the $1,000 that he earned while he owned the shares.
  • For Investor B to pay taxes upfront, he has to have some additional money set aside OR have other assets. If he has no money set aside, then other assets may have to be sold to pay taxes. This forced sale may lead to a loss (selling low, bought high) OR may lead to more taxation due to capital gains. This is the other main disadvantage of mutual funds.

Compared to other forms of investments, the only issue with a mutual fund is the timing of the taxes paid, not the amount of taxes paid.

  • Taxes may be paid sooner (if gains accrued before purchase are realized and distributed) or
  • Taxes may be paid later (if losses accrued before purchase offset realized gains)
  • But total taxes paid will be the same.

Reference:

I read many web links to understand this, but I will list one main link that was helpful to me with actual examples.