A 'Chicken' Way to Lighten Up on Lofty Positions
Deploying mutual fund and capital gains distributions can be a risk-reduction tool for your portfolio.
Like picking a favorite color or deciding which baseball team to root for (or whether to be a baseball fan at all), the decision about whether to reinvest your mutual funds' capital gains and dividend distributions is probably one that you made when you first got started investing and never revisited. After an initial "what does this mean?" moment, you probably checked the box to reinvest and never gave it a second thought.
And to be sure, reinvesting those distributions is the path of least resistance: It simplifies account maintenance and keeps the money in your account to grow.
But is reinvesting dividend and capital gains distributions the right decision in every situation? Not necessarily. Entering retirement--when you're drawing upon your portfolio rather than accumulating assets in it--is a natural inflection point to revisit whether to reinvest those distributions or do something else with them. Many retirees reasonably reckon that if they're going to be extracting cash flows from their portfolios for living expenses in retirement, their portfolios' naturally occurring distributions are as good as any place to start. I often hear from retirees whose equity dividends supply them with all the cash flows they need and then some.
But there's another valid reason to skip the reinvestment--and it's especially relevant right now, with the markets scraping new highs almost daily. While you might not think of it this way, reinvesting dividends and capital gains distributions back into a holding can be seen as a sort of tacit endorsement of it. After all, those reinvestments mean you're adding to your position, albeit in small increments. By the same token, you can think of not reinvesting as a tool to lighten up your position, albeit in an incremental way.
Not reinvesting dividends and capital gains may be especially useful for taxable holdings that have appreciated but that you'd like to lighten up on. In contrast with tax-sheltered accounts, where you're free to reposition all day long without a tax bill as long as the money stays inside the account, selling positions outright from a taxable account can trigger a tax bill. Meanwhile, not reinvesting distributions back into a holding in your taxable account is a wash from a tax standpoint versus reinvesting them. Thus, forgoing those reinvestments is a way to reduce your commitment to a holding--again, in a modest way--without actually selling.
Sizing Up the Options
Before we go any further, let's first discuss exactly what your options are with respect to reinvestment. First, you can check the box and reinvest both dividends and capital gains distributions. Doing so effectively enlarges your position as you go along, even if you're not making new contributions with new money. For that reason, reinvesting dividends and capital gains is very often the best choice for people whose aim is to increase their assets over time. Dividends have historically composed a large share of the equity market's return (though estimates vary as to exactly how much). And as a bond investor, most of the return you earn comes from income. If you're looking to grow your wealth rather than live off of it, reinvesting is close to a no-brainer.
Second, you could forego reinvestment and spend the funds instead. That route could grow more appealing as you enter retirement and are looking for your portfolio to replace some of the income that you had by when you were working. If you're using the bucket strategy, for example, you could have your distributions sent to your cash account to help meet your living expenses.
The third option would be to forego reinvestment but use the proceeds to invest in a different holding. This is the strategy that seems worthy of consideration given the current point in the market cycle. You might choose this route if you'd like to maintain some exposure in the position that's kicking off the distributions but don't want to dedicate new money to it. For example, perhaps because you've long maintained a position in a technology sector fund that has grown by leaps and bounds and now occupies too large a position in your portfolio. Selling altogether would trigger a big capital gains bill, assuming you hold the position in a taxable account. By not reinvesting your distributions, you're at least not making additional commitments to the position you don't want to grow any larger.
You can then direct those distributions to positions that you'd like to top up. If retirement is fast approaching, for example, you might take distributions from appreciated equity holdings and deploy them into bonds or even cash. Alternatively, you might use distributions to adjust your intra-asset-class positioning, distributions from growth-oriented holdings and shifting them into value, or using distributions from appreciated U.S. equity positions to add to international holdings.
Taking that kind of action is especially relevant right now, given that mutual funds often make their capital gains distributions in the fourth quarter, and distributions from some funds in recent years have exceeded 10% of their net asset values. (Given this year's rising equity market and ongoing outflows from actively managed funds, I would expect to see another doozy of a capital gains distribution season in 2019.) By opting to not have those distributions reinvested, you can effectively lighten your commitment to the holding. For example, let's say the aforementioned technology-sector fund pays out 12% of its NAV in December. By opting to not reinvest the distribution back into the account, you've effectively lightened your position by 12%.
Of course you'll still owe taxes on that distribution, assuming you hold the fund in a taxable account; from a pure tax standpoint, you'd rather have fewer or no distributions from your taxable holdings. But if a fund makes a distribution, you won't owe more if you don't reinvest that distribution than if you do.
When you receive distributions from mutual funds you hold in your taxable account, you'll receive a 1099 detailing the distribution. You'll owe taxes on the distribution for the year in which you received it. The taxes you owe that year are the same regardless of whether you spend the distributions, reinvest them, or take them and move them into another holding.
Now, it's absolutely true that if you reinvest, that increases your cost basis in the position by the amount of the distribution. When you go to sell the position, the taxes you owe would be based on the differential between your cost basis, which has been adjusted upward to reflect any distributions you received and reinvested, and the sales price. But that cost-basis accounting simply helps ensure that you don't pay taxes on that distribution twice; it doesn't help you actually reduce your taxes versus taking the distribution and spending it or reinvesting it in other positions.
Can you forgo reinvestment in tax-sheltered accounts and use those distributions to reposition your portfolio? Yes, but you probably don't need to get into that. That's because tax-sheltered accounts inherently leave you more room to reposition. You can sell positions outright without tax consequence as long as the money stays within the account; there's no good reason to toil around the margins by tinkering with reinvestments.
On the other hand, if you've entered drawdown mode and are actively pulling from your tax-sheltered retirement portfolio for living expenses, you might consider using dividend and capital gains distributions to help meet your withdrawal needs; after all, the tax consequences are the same regardless of whether the withdrawals come from dividend/capital gains distributions or outright withdrawals of principal. At the same time, you can be artful about which distributions you pocket and which holdings you reinvest back into. If a holding is depressed and you think it's due for a recovery, for example, you can reinvest its distributions while pulling from positions that are more lofty.
Introducing Morningstar's New Podcast: The Long View
Expand your investing horizons and look to the long term. Join hosts Christine Benz and Jeff Ptak each week on The Long View for wide-ranging conversations with leaders in investing, advice, and personal finance. Subscribe to and rate the podcast today, and access every episode here.