Why do funds and ETFs in US not capitalize dividends?

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AppelSienSapFrietjes
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Why do funds and ETFs in US not capitalize dividends?

Post by AppelSienSapFrietjes » Thu Jun 20, 2013 5:55 am

I am from Europe/Belgium and in Europe it is common to have funds and ETFs which capitalize/re-invest instead of distribute the dividends. I have been looking to the Vanguard ETFs and funds lately, and I noticed that all of them distribute the dividends, usually quarterly. Why is that?

Capitalizing the dividends is very interesting TAX-wise. Some calculations:

Say you have a dividend yield of 3%. Here in Belgium, we have to pay 25% on dividends. In essence, this means that the TER of the fund or ETF increases with 0.03 * 0.25 = 0.75%. Say the TER of the fund of ETF is 0.50%. Adding 0.75%, it is now 1.25%! Suddenly, your fund of ETF is very expensive (in my opinion).

Hence, I almost exclusively invest in funds or ETFs which capitalize the dividends. My only exception are funds or ETFs which have a low or no dividend yield (such as commodities, emerging markets small cap, ...).

Why is this uncommon in US? At first, Vanguards funds or ETFs are very interesting, because of their very low TER, but because of the distributions, it becomes very costly.

Thanks.

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Epsilon Delta
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Re: Why do funds and ETFs in US not capitalize dividends?

Post by Epsilon Delta » Thu Jun 20, 2013 11:40 am

AppelSienSapFrietjes wrote:I am from Europe/Belgium and in Europe it is common to have funds and ETFs which capitalize/re-invest instead of distribute the dividends. I have been looking to the Vanguard ETFs and funds lately, and I noticed that all of them distribute the dividends, usually quarterly. Why is that?

Capitalizing the dividends is very interesting TAX-wise. Some calculations:

Say you have a dividend yield of 3%. Here in Belgium, we have to pay 25% on dividends. In essence, this means that the TER of the fund or ETF increases with 0.03 * 0.25 = 0.75%. Say the TER of the fund of ETF is 0.50%. Adding 0.75%, it is now 1.25%! Suddenly, your fund of ETF is very expensive (in my opinion).

Hence, I almost exclusively invest in funds or ETFs which capitalize the dividends. My only exception are funds or ETFs which have a low or no dividend yield (such as commodities, emerging markets small cap, ...).

Why is this uncommon in US? At first, Vanguards funds or ETFs are very interesting, because of their very low TER, but because of the distributions, it becomes very costly.

Thanks.
Because US mutual fund and tax law does not allow it. US law requires mutual funds to distribute all of their income yearly. If a US person is unwise enough to buy a foreign fund that capitalizes dividends they still have to declare the income and what a mess that is.

hafius500
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Re: Why do funds and ETFs in US not capitalize dividends?

Post by hafius500 » Thu Jun 20, 2013 1:45 pm

AppelSienSapFrietjes wrote:I am from Europe/Belgium and in Europe it is common to have funds and ETFs which capitalize/re-invest instead of distribute the dividends. I have been looking to the Vanguard ETFs and funds lately, and I noticed that all of them distribute the dividends, usually quarterly. Why is that?

Capitalizing the dividends is very interesting TAX-wise. Some calculations:

Say you have a dividend yield of 3%. Here in Belgium, we have to pay 25% on dividends. In essence, this means that the TER of the fund or ETF increases with 0.03 * 0.25 = 0.75%. Say the TER of the fund of ETF is 0.50%. Adding 0.75%, it is now 1.25%! Suddenly, your fund of ETF is very expensive (in my opinion).

Hence, I almost exclusively invest in funds or ETFs which capitalize the dividends. My only exception are funds or ETFs which have a low or no dividend yield (such as commodities, emerging markets small cap, ...).

Why is this uncommon in US? At first, Vanguards funds or ETFs are very interesting, because of their very low TER, but because of the distributions, it becomes very costly.

Thanks.
I have been looking to the Vanguard ETFs and funds lately, and I noticed that all of them distribute the dividends, usually quarterly.
Lots of Europe-based funds/ETFs (including Vanguard Irleand?) offer accumulating shares.
If you think of buying US-based unregistered funds (e.g., US-based Vanguard funds/ETFs), be aware of disadvantageous tax consequences (*).
Capitalizing the dividends is very interesting TAX-wise.
It happens very often that European posters claim that "their" capitalizing funds are "tax-free" or treated "more favorably" than distributing funds.

Maybe that investors do not understand how capitalizing funds are taxed.
Maybe there are countries where such advantages exist, -or where stupid investors buy distributing shares while smart investors buy accumulating shares of the same fund. In deed, it is not unusual that a fund company offers both distributing AND accumulating shares.

Why would your tax authority allow that investors in accumulating funds pay less taxes?

In fact, the taxation of accumulating shares can be risky.
In some/many? countries accumulating funds are double-taxed.
It is assumed that the accumulated dividends or interest payments or realized capital gains were distributed annually (e.g., on the last day of the fiscal year)[*- "deemed distributions"]. You have to pay taxes on these earnings every year.
When you sell the fund, your broker deducts a flat tax on all accumulated earnings since you bought the fund.
To reclaim the taxes you already had payed you must prove that you had already payed these taxes annually. Good luck!

You must hope that your broker and your tax authority stored all data on annual taxes and your personal tax payments (maybe, over decades) AND that your broker calculated the flat tax correctly AND that your tax authority correctly figured out how much of the taxes you can reclaim.

Check out the local discussion forums and you can find endless discussions about the 'horrors' of owning capitalising offshore (**) funds.

From the viewpoint of portfolio management capitalizing funds make no sense in most cases.
You may want to rebalance or you may want to make opportunistic purchases or you may want to increase your exposure to less risky asset-classes because you grow older.
Or the retired investor may want income without need to trade shares. In all of these cases, you don't want to reinvest the distribution in the same fund and you would save transaction costs because you don't need to sell shares.

(*) Example KPMG quote
(**) the taxation of onshore capitalising funds can be easy and riskless.
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Topic Author
AppelSienSapFrietjes
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Re: Why do funds and ETFs in US not capitalize dividends?

Post by AppelSienSapFrietjes » Thu Jun 20, 2013 2:04 pm

I guess I am lucky. Belgium does not have any capital gain taxes. See:

http://www.bespaarbelastingen.be/algeme ... tax-haven/
http://www.taxbites.be/taxation/content/view/64/42/

I did not realize Belgium was an exception. Hence my question in the first post.

Though, we have taxes on dividends (25%).

Is it then true that we are indeed better off buying capitalizing funds instead of distributing funds?

Chrysalis
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Re: Why do funds and ETFs in US not capitalize dividends?

Post by Chrysalis » Thu Jun 20, 2013 2:31 pm

I am in the UK, and here, accumulating mutual funds and capitalising ETFs are taxed exactly the same as distributing ones. Dividends (or effective distributions made within the accumulating fund) are taxed as income, and capital gain taxed as capital gain. In a taxable account, it makes tax calculations much more complex as the components of the return need to be separately recorded and accounted.
there is still a place for them though, in tax sheltered accounts, as they avoid the need to reinvest dividends.

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Epsilon Delta
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Re: Why do funds and ETFs in US not capitalize dividends?

Post by Epsilon Delta » Thu Jun 20, 2013 3:51 pm

AppelSienSapFrietjes wrote:I guess I am lucky. Belgium does not have any capital gain taxes.

Though, we have taxes on dividends (25%).

Is it then true that we are indeed better off buying capitalizing funds instead of distributing funds?
You will have to ask a Belgian.
Note that it is not enough that there is no capital gains tax. You also need to check that there is no tax on undistributed dividends.

skylar
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Re: Why do funds and ETFs in US not capitalize dividends?

Post by skylar » Thu Jun 20, 2013 6:52 pm

The S&P 500 fund in my 457b plan does this. It took me a while to figure out what was happening to the dividends - the NAV would stay the same when my regular S&P 500 fund would just distribute a dividend and drop its NAV. The catch is that it's a collective trust and offered directly to the 457b, so you can't buy this on your own in a taxable account.

curmudgeon
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Re: Why do funds and ETFs in US not capitalize dividends?

Post by curmudgeon » Fri Jun 21, 2013 12:25 am

Berkshire Hathaway seems to be the most well known example of effectively capitalizing dividends without tax consequences (at least as I understand it). For people who are have substantial non-tax-sheltered investment accounts, that can be quite attractive. I've been mildly curious as to what quirk allows it to operate this way, and whether there are other similar investment vehicles.

Anybody with more knowledge on Berkshire want to comment?

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Frengo
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Re: Why do funds and ETFs in US not capitalize dividends?

Post by Frengo » Fri Jun 21, 2013 2:02 am

I don't think Berkshire is a regulated investment fund. They can do whatever they like with their earnings. After paying corporate taxes, that is.

NHRATA01
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Re: Why do funds and ETFs in US not capitalize dividends?

Post by NHRATA01 » Fri Jun 21, 2013 9:54 am

skylar wrote:The S&P 500 fund in my 457b plan does this. It took me a while to figure out what was happening to the dividends - the NAV would stay the same when my regular S&P 500 fund would just distribute a dividend and drop its NAV. The catch is that it's a collective trust and offered directly to the 457b, so you can't buy this on your own in a taxable account.
I think that sounds a bit like a unitized fund, which are the core index offerings in my 401K.

hafius500
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Re: Why do funds and ETFs in US not capitalize dividends?

Post by hafius500 » Fri Jun 21, 2013 2:05 pm

Theoretically, accumulating funds might have a -small- advantage if the accumulated dividends, interest payments or realized capital gains were not taxed annually, but when the shares were sold. In this case you could profit from a small compounding effect because you could earn the additional return on the postponed taxes.

If I recall, a Norwegian investor recently wrote that most Norw.funds accumulate and are taxed when they are sold.

It is possible (in other countries) that accumulating physical (replicating) and accumulating synthetic (swap-based) funds are treated differently.
Swap funds have earnings from derivatives and these earnings could be taxable annually if the fund distributes earnings ("bad") and they could be taxed when the fund is sold ("good") if the fund accumulates earnings.
Physical funds have earnings from dividends, interest and realized capital gains, and they could be taxed annually irrespective of whether the fund distributes or accumulates earnings.

Therefore, all depends on the local tax laws.
If only dividends (and interest?) were taxed, I should ask myself if it would make sense to invest in high-yielding asset-classes (high-yield bonds, high-dividend stocks, maybe even value stocks).
Usually, the domestic websites of mutual-fund or ETF-companies have broschures that explain (the difference between) the taxation of distributing and accumulating shares.
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Rainier
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Re: Why do funds and ETFs in US not capitalize dividends?

Post by Rainier » Fri Jun 21, 2013 2:23 pm

AppelSienSapFrietjes wrote:I guess I am lucky. Belgium does not have any capital gain taxes. See:

http://www.bespaarbelastingen.be/algeme ... tax-haven/
http://www.taxbites.be/taxation/content/view/64/42/

I did not realize Belgium was an exception. Hence my question in the first post.

Though, we have taxes on dividends (25%).

Is it then true that we are indeed better off buying capitalizing funds instead of distributing funds?
What's the income tax rate in Belgium?

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AppelSienSapFrietjes
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Re: Why do funds and ETFs in US not capitalize dividends?

Post by AppelSienSapFrietjes » Tue Jun 25, 2013 11:21 am

Income tax is around 40-50% in Belgium.

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AppelSienSapFrietjes
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Re: Why do funds and ETFs in US not capitalize dividends?

Post by AppelSienSapFrietjes » Tue Jun 25, 2013 11:23 am

hafius500 wrote:Theoretically, accumulating funds might have a -small- advantage if the accumulated dividends, interest payments or realized capital gains were not taxed annually, but when the shares were sold. In this case you could profit from a small compounding effect because you could earn the additional return on the postponed taxes.

If I recall, a Norwegian investor recently wrote that most Norw.funds accumulate and are taxed when they are sold.

It is possible (in other countries) that accumulating physical (replicating) and accumulating synthetic (swap-based) funds are treated differently.
Swap funds have earnings from derivatives and these earnings could be taxable annually if the fund distributes earnings ("bad") and they could be taxed when the fund is sold ("good") if the fund accumulates earnings.
Physical funds have earnings from dividends, interest and realized capital gains, and they could be taxed annually irrespective of whether the fund distributes or accumulates earnings.

Therefore, all depends on the local tax laws.
If only dividends (and interest?) were taxed, I should ask myself if it would make sense to invest in high-yielding asset-classes (high-yield bonds, high-dividend stocks, maybe even value stocks).
Usually, the domestic websites of mutual-fund or ETF-companies have broschures that explain (the difference between) the taxation of distributing and accumulating shares.
Thanks for your answer. I don't think the compounding effect is "small". See my explanation in original post:

"Say you have a dividend yield of 3%. Here in Belgium, we have to pay 25% on dividends. In essence, this means that the TER of the fund or ETF increases with 0.03 * 0.25 = 0.75%. Say the TER of the fund of ETF is 0.50%. Adding 0.75%, it is now 1.25%! Suddenly, your fund of ETF is very expensive (in my opinion)."

An extra 0.75% is a lot for buy-and-hold, in my opinion.

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dm200
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Re: Why do funds and ETFs in US not capitalize dividends?

Post by dm200 » Tue Jun 25, 2013 11:33 am

You sometimes see the difference in 401k (and perhaps 403b) accounts. If these accounts hold actual mutual funds (with a symbol, full prospectus, etc.), there are dividend and capital gains distributions inside the account, and you will see the number of shares go up and the NAV adjust downward. On the other hand, if your 401k uses a different kind of "fund" that is not an actual mutual fund, then you will see the NAV keep increasing as dividends and capital gains (realized and unrealized) accumulate.

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Re: Why do funds and ETFs in US not capitalize dividends?

Post by 22twain » Tue Jun 25, 2013 2:56 pm

dm200 wrote:if your 401k uses a different kind of "fund" that is not an actual mutual fund, then you will see the NAV keep increasing as dividends and capital gains (realized and unrealized) accumulate.
This is true of the CREF Stock account in my TIAA-CREF 403(b) plan. The number of units (note they're not called "shares") increases only when my employer and I make contributions. Any dividends and capital gains distributions from the underlying stocks are rolled into the per-unit value.
My investing princiPLEs do not include absolutely preserving princiPAL.

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