The tax implications of which date you buy shares having ex-dividends
Fact checked by Suzanne KvilhaugReviewed by Andy SmithFact checked by Suzanne KvilhaugReviewed by Andy Smith
The ex-dividend date is the demarkation date when investors who hold a common stock will receive the dividend payment. Also known as the ex-date, this day is usually one business day prior to the dividend record date. There are ways that investors can use the ex-dividend date to their advantage.
A common stock‘s ex-dividend price behavior is a continuing source of confusion to investors. Read on to learn about what happens to the market value of a share of stock when it goes “ex” (as in ex-dividend) and why. We’ll also provide some ideas that may help you hang on to more of your hard-earned dollars.
Key Takeaways
- When buying and selling stock, it’s important to pay attention not just to the ex-dividend date, but also to the record and settlement dates in order to avoid negative tax consequences.
- The value of a share of stock goes down by about the dividend amount when the stock goes ex-dividend.
- Investors who own mutual funds, stocks, and other securities should find out the ex-dividend date for those investments and evaluate how the distribution will affect their tax bill.
How Does It Work?
Let’s take, for example, a company called Jack Russell Terriers Inc. that trades on the Nasdaq under the truly appropriate symbol “HYPER” and that’s currently priced at $10 per share. Due to the popularity of Jack Russell Terriers, HYPER has had record earnings, so the board of directors decided to declare a special extra dividend of $1 per share with a record date of Tuesday, March 19, 2019. The ex-dividend date, or ex-date, will be one business day earlier, on Monday, March 18.
If you buy the stock on Friday, March 15, you will get the $1 dividend because the stock is trading with (or “cum“) dividend. If you wait to buy the stock until Monday, March 18, you are not entitled to the $1 annual dividend. Keep in mind that the purchase date and ownership dates differ. In 2017, the settlement date for marketable securities was reduced from three to two days. So, to own shares on the record date—i.e., to be a shareholder of record for Tuesday, March 19—you have to buy the shares a day before the ex-dividend date. Further, if you sell the shares before the ex-date, you won’t be seen as a shareholder and won’t receive the dividend.
The Stock’s Value
What will happen to the value of the stock between the close on Friday and the open on Monday? Well, if you think about it within the context of actual value, this stock is truly worth $1 less on Monday, March 18, than it was on Friday, March 15. So its price should drop by approximately this amount between the close of business on Friday and the open of business on Monday.
Important
Stock purchase and ownership dates are not the same; to be a shareholder of record of a stock, you must buy shares two days before the settlement date.
In general, we would expect that the value of a share of HYPER stock would go down by about the dividend amount ($1) when the stock goes ex-dividend. The term “about” is used loosely here because dividends are taxed, and the actual price drop may be closer to the after-tax value of the dividend. This is a bit difficult to measure, as different tax rates and rules apply to different buyers, but it would be safe to assume that it should drop about 15%, as HYPER pays a qualified dividend.
Let’s say that Bob is excited about HYPER’s earnings and buys 100 shares on Friday, March 15, for settlement on Tuesday, March 19, at a price of $10 per share. What happens? As you know, the ex-date is one business day before the date of record. The stock will go ex-dividend (trade without entitlement to the dividend payment) on Monday, March 18, 2019. Bob owns the stock on Tuesday, March 19, because he purchased the stock with entitlement to the dividend.
In other words, Bob will receive a dividend distribution of $100 ($1 x 100 shares). His check will be mailed on Wednesday, March 20, 2019 (dividend checks are mailed or electronically transferred out the day after the record date). When the stock goes ex-dividend on Monday, March 18, its value will drop by about $0.85 ($1 x 0.85 [1 – the tax bracket]). So, on the following day, in theory, the stock should be trading for approximately $9.15 (or $10 – $0.85).
Think Before You Act
Now that you understand how the price behaves, let’s consider whether Bob needs to be concerned about this or not. If he is buying HYPER in a qualified account (in other words, an IRA, 401(k) or any other tax-deferred account), then he should not worry too much, because he doesn’t owe taxes until he withdraws his money or, if he makes his purchase in a Roth IRA, they are not due at all.
However, if Bob buys HYPER in a non-qualified, currently taxable account, he really needs to be careful. Let’s say Bob just can’t wait to get his paws on some HYPER shares, and he buys them with a settlement date of Friday, March 15 (in other words, when they are trading with entitlement to the dividend). He pays $10 per share. Suppose that the very next day, HYPER drops to approximately $9.15. Bob will have an unrealized capital loss and, to add insult to injury, he will have to pay taxes on the dividend he receives. Bob’s portfolio will lose money and he will owe money to Uncle Sam on the $100 in dividends that he receives! Clearly, Bob should have bought HYPER shares on the first ex-dividend day and paid the lower price, allowing him to avoid owing Uncle Sam taxes on the $0.85 he lost.
Mutual Funds
This scenario also needs to be considered when buying mutual funds, which pay out profits to fund shareholders.
By law, mutual funds must distribute profits from the sale of securities in the fund to the fundholders each year in the form of income dividends and/or short– and long-term capital gains, even if the value of their actual mutual fund’s NAV drops. This distribution to the fundholders is a taxable event, even if the fundholder is reinvesting dividends and capital gains.
Why don’t mutual funds just keep the profits and reinvest them? Under the Investment Company Act of 1940, a fund is allowed to distribute virtually all of its earnings to the fund shareholders and avoid paying corporate tax on its trading profits. By doing this, it can lower fund expenses (taxes are, of course, a cost of doing business), which increases returns and makes the fund’s results appear much more robust.
What’s an investor to do? Well, just like the HYPER example, investors should find out when the fund is going to go “ex” (this usually occurs at the end of the year, but start calling your fund in October). If you have current investments in the fund, evaluate how this distribution will affect your tax bill. If you purchased shares that are currently trading for less than the price you paid for them, you may consider selling to take the tax loss and avoid tax payments on the fund distributions. If you are thinking about making a new or additional purchase to a mutual fund, do it after the ex-dividend date.
The Bottom Line
It’s not what you make that really matters—it’s what you keep. Being mindful of these ex-dividend circumstances should help you keep more of your hard-earned dollars in your pocket and out of the IRS coffers.
Read the original article on Investopedia.