Return of capital is something I’ve encountered a lot throughout my stock market research,
and it’s been a recurring subject in many of my videos.
Unfortunately, because it’s such a complicated and misunderstood issue, I’ve never given
it the full attention it deserves when I’ve previously touched on it.
So I figured it was time to do a whole video about return of capital distributions to help
people navigate this tricky component of dividend and income-focused investments.
To start us off, I’ll explain exactly what a return capital is and the types of investments
that might include this in their dividend distributions.
Beyond that, the most crucial knowledge surrounding return of capital comes down to understanding
how it’s taxed.
I’ll break this down in detail so we can understand how it may help or hurt our investment
goals.
There’s also a lot of confusion around how it works within tax-sheltered retirement accounts,
so I’ll clear that up too.
Then, we’ll discuss whether return of capital is a red flag when it comes to selecting an
investment.
I thought it was for a while, but I recently learned that it can be either good or bad
depending on how it’s used.
So we’ll talk about how to tell the difference between the two, then we’ll wrap things
up with some tips on navigating return of capital in your investments.
Let’s take a look!
To put it simply, a return of capital is when you receive a dividend distribution that contains
cash from your initial investment.
In this scenario, cash is literally being returned from the initial capital that you
bought shares with.
Return of capital is primarily seen in investment funds, which includes things like mutual funds,
closed-end funds, master limited partnerships, real estate investment trusts and business
development companies.
It’s most commonly seen in income-focused funds and investments, because it’s a tool
that can be used to provide higher distributions to shareholders.
Usually, funds will pay distributions to investors using the dividends, interest or capital gains
that they’ve collected from the fund’s holdings.
But, the market doesn’t always behave as expected, and this means that the fund may
not generate enough earnings to fulfill their desired distribution rate.
In these cases, they can use a return of capital to provide that targeted distribution rate.
Motivations for this may include staying competitive with other funds, or, delivering a level of
dividend income that has been previously advertised or that investors have come to expect.
Since the cash used from return of capital doesn’t come from capital gains, dividends
or interest, it technically comes from the fund’s NAV, or net asset value, which includes
whatever cash the fund has on the sidelines.
This can include income that’s been accumulated in previous years or cash from new investors
buying into the fund.
However, it can also technically be taken from unrealized gains, which is when your
initial investment in the fund has appreciated in value, but it hasn’t been sold.
To me, this kind of seems like a sneaky way for funds to designate a distribution as a
return of capital, but in any case, it gives them more flexibility in how they use this
type of distribution.
The important thing to consider, though, is how a return of capital impacts us as investors,
specifically regarding taxes and the value of our investment.
As you probably know, dividends, interest and capital gains distributions are all subject
to taxes, being designated as either short-term capital gains or long-term capital gains depending
on the type of distribution.
However, a return of capital is not a taxable event, because on paper, you’re just getting
back the money that you initially invested.
This means when you receive a return of capital distribution, you owe no immediate taxes on
it whatsoever.
In the short-term, this can make a return of capital very attractive for investors.
While other dividends may require paying taxes upwards of 15%, you get to keep 100% of the
cash from a return of capital.
However, this does impact your adjusted cost basis, which will have additional tax implications.
Your cost basis is whatever you paid for the investment.
To work through an example, we’ll say you bought 1 share of a hypothetical income ETF
for $20, making your cost basis $20.
We’ll also say you received an annual distribution of $2, which was made up entirely of a return
of capital.
As we stated earlier, the return of capital technically comes from the cash you initially
invested - this means it will DECREASE the cost basis of your investment.
So in this example, you paid $20 for your share, but it distributed $2 via a return
of capital.
Your cost basis in this investment is now $18, since you received $2 of your initial
investment back.
Now at this point, you’ve received $2 completely tax free, and you still own 1 whole share
that’s valued at $20.
But, since the cost basis in your investment went down, you’ll experience a tax burden
if you ever decide to sell your shares.
If you decided to sell your share for $20, with your adjusted cost basis at $18, you
will now owe capital gains tax on the difference between your cost basis and the market price.
In this case, it means you would now owe capital gains tax on the $2 of distributions that
you previously received tax-free.
And in this situation, you can refer to whatever your capital gains tax would be for the scenario,
either short-term or long-term depending on how long you’ve held the shares.
Because of this unique treatment, return of capital distributions are often referred to
as tax-deferred.
You don’t owe taxes when you receive them, because they’re deferred to the point in
time when you sell your shares.
Once the shares are sold, you officially realize those gains and you’ll owe taxes then.
This can have huge benefits if you understand the tax repercussions of a return of capital
and how to use them to your advantage.
Ultimately, it gives investors more control on when they realize their tax obligations,
providing a little more flexibility.
I’ll outline three potential outcomes.
The first outcome is you collect a return of capital but sell your shares within one
year of purchasing them.
In my opinion, this is kind of a waste, because you’ll end up owing short-term capital gains
taxes on the distributions you received due to the short holding period.
In this case, the return of capital provided little to no benefit to you.
The next scenario is you hold your shares for longer than a year while your cost basis
slowly decreases.
This can provide some considerable benefit, because when you do sell your shares, you’ll
owe long-term capital gains instead of short-term capital gains on all of the distributions
you received.
You’ll also get the benefit of collecting tax-free dividends until that point, which
you can use 100% of to reinvest or spend elsewhere.
This may be preferable for investors who are seeking high dividend yields, especially when
in many cases these higher dividends are taxed as income at the short-term capital gains
tax rate.
The final outcome is you never sell your shares.
And yes, if you hold long enough, this means your cost basis will eventually drop to zero
dollars.
Once this happens, any subsequent distributions you receive will be taxed at the long-term
capital gains tax rate.
So this can be a great outcome if you find an investment you want to hold for your lifetime.
In this scenario, you’ll enjoy several years of tax-free distributions, before reaching
a cost basis of zero and receiving distributions at that lower long-term tax rate - which still
might pay more than a high-yield investment taxed as income.
Of course, all of this assumes that the shares trade flat while you hold your investment.
It’s also possible for the shares to decrease in value, which may reduce your tax obligation
when you sell your shares, or for them to appreciate in value, which may result in capital
gains taxes on more than what you received in return of capital distributions.
In any case, there are certainly some benefits to receiving return of capital for long-term
investors, as long as you understand how it works and you monitor the exact numbers and
figures.
With its long-term benefits, many people assume that investments paying out return of capital
distributions are a great fit for retirement accounts like 401ks, traditional IRAs and
Roth IRAs.
However, this may not be the case, and I’ll break it down for both pre-tax and post-tax
accounts.
Consider a traditional IRA or 401k, where you don’t pay taxes on the money you invest
into the account.
You also won’t pay taxes on any dividends or stock trades you make inside the account,
you only pay income taxes on whatever you withdraw during retirement.
So if you invest in a high-yield fund that pays return of capital distributions, the
designation as a return of capital doesn’t really matter - you’ll be accumulating them
tax-free no matter what kind of dividend they are.
Furthermore, you don’t have to worry about decreasing your cost basis, because if you
ever sell your shares, you don’t pay taxes inside the account anyway.
The important thing to consider is that you WILL pay taxes when you withdraw money from
the account.
So if you built up $1,000 in cash of return of capital distributions, you’ll be forced
to pay income taxes on it when you withdraw from the account.
In comparison, if you just held these shares in a taxable account and collected the $1,000
of return of capital distributions there, you wouldn’t owe taxes on them at all until
you sold your shares or your cost basis hit zero.
And if either of these things ever happened, you’d only owe long-term capital gains taxes
instead of income tax coming out of the retirement account.
So these retirement accounts kind of eliminate the tax benefits of return of capital, which
in my opinion, is one of the only reasons to seek out these distributions in the first
place.
But, they still accumulate and compound over time like any other dividend, so if you really
believe in the investment and want to hold it long-term, putting it in your IRA or 401k
isn’t the worst possible idea.
I personally just think it makes more sense in a standard taxable account, where you can
get the most out of the tax-deferred benefits.
Return of capital works a little better in a Roth IRA, which is funded with post-tax
income.
This means your withdrawals in retirement are tax-free.
Just like the other accounts, if you receive return of capital distributions, they’re
building up tax-free in the account.
So again, they don’t provide any substantial benefit over another type of dividend unless
you’re really attached to the investment.
But at least when you withdraw from a Roth IRA, you won’t owe income tax on it, so
you’re not erasing any of the benefits of return of capital distributions.
So overall, unless you really like the investment, there’s no great reason to seek out return
of capital for retirement accounts, because their benefits are so much more impactful
within a taxable account.
But before you go and load up your taxable accounts with investments that pay return
of capital, let’s consider why you might actually want to avoid this tax-deferred distribution
strategy.
A return of capital isn’t always a good thing.
In fact, it can be a huge red flag that an investment fund isn’t generating enough
returns to continue driving portfolio growth and providing distributions to investors.
As we mentioned earlier, funds will often use this strategy when they haven’t generated
enough returns from underlying investments to pay their desired distribution rates.
If you expect a 5% yield but a fund only generates a 3% yield from their investments, they’ll
use a return of capital to fulfill that 5% and keep investors happy.
However, if this continues over the long-term, it can be very dangerous for the longevity
of the fund.
Over time, if the fund fails to produce enough returns and continues paying out distributions
from its NAV, the NAV will decrease.
And obviously this isn’t sustainable, because it will eventually go to zero if it’s paying
out more money than it’s earning.
For this reason, I always assumed a return of capital was bad - I thought it was a clear
signal that the fund wasn’t generating enough profits to fulfill distributions.
However, when doing some research on the Nationwide Risk-Managed Income ETF, ticker NUSI, I found
a great article that explained why this isn’t always the case.
There are actually some clever strategies with return of capital that funds can use
to give investors the flexibility with distributions that we covered earlier in this video.
From the perspective of the investment fund, return of capital has a couple of benefits
that will then get passed through to investors.
First, it helps limit additional taxes.
We can imagine a scenario like before where a fund is targeting a 5% distribution rate,
but they've only earned as much as 3% from their income strategies.
If they’re holding stocks that have gone up in value, they could sell those shares
to realize capital gains and fulfill the rest of that 5% distribution.
However, this creates either short-term or long-term capital gains tax obligations, and
may reduce the potential growth of the fund in the future.
Instead, the fund can choose a return of capital and avoid immediate taxes altogether.
Additionally, funds can use capital losses to cancel out capital gains for the year,
and then classify a distribution as a return of capital even when they’ve been profitable.
The next benefit is that return of capital gives funds more consistency with distributions,
which can be important for monthly dividend payers.
Whether the fund has to manage volatility in the market or inconsistency with income
from the underlying holdings, return of capital is a useful tool for keeping their distributions
steady and predictable.
These strategies mean that return of capital alone isn’t a red flag, but it does require
a closer look to determine whether it’s a constructive or destructive return of capital.
A constructive return of capital would be a good thing, because it means the fund is
using it to improve the fund’s performance and give investors more flexibility.
To determine if a return of capital is constructive, we need to look at the fund’s distribution
rate and compare it to their total returns.
Specifically, we want to find out how these distributions compare to the fund’s NAV.
If the fund is paying out any return of capital and the NAV is growing, it could be considered
a constructive return of capital.
This would be present in a fund with a total return greater than the distribution rate.
It shows that the distribution of return of capital is not negatively impacting the fund’s
NAV, in other words, return of capital is not hurting the growth of the fund.
This means that investors can enjoy tax-deferred distributions without the value of their initial
investment eroding.
On the other hand, a destructive return of capital can be identified when the distributions
of the fund are greater than the total returns.
This means that the return of capital distributions are eating away at the NAV, eroding your initial
investment and threatening future distributions.
It’s also possible that there’s a mix of both going on, which is why it’s important
to understand all of the aspects of return of capital and take a closer look at any investments
that use these distributions.
But now that we’ve covered the basics of return of capital distributions, I want to
provide a few extra notes on navigating the investments that use them.
First of all, you won’t be able to tell if an investment uses return of capital by
looking at the dividend yield or distribution rate alone.
So if you’re investing in any of the assets I mentioned earlier, you may want to take
a closer look to figure out if and how they use return of capital.
You can usually find this information on the website of the investment in question.
Second, you’ll have to keep an eye on return of capital figures, because they can vary
with each distribution.
Some funds make a habit of using them, while others may only use them occasionally.
Most funds typically provide the final numbers for their use of return of capital at the
end of the tax year, which you’ll need to use to figure out your adjusted cost-basis
in case your broker doesn’t track it for you.
It can definitely get complicated, so that’s what I hire a tax advisor for.
And speaking of tax advisors, please consider consulting a professional in the industry
if you expect return of capital to be a large part of your investment strategy.
I’ve done my best to give you the basics here, but I’m sure there are some more complicated
scenarios out there that require a closer look and verification by someone more qualified
than myself.
But that’ll do it for me today, so if you have any questions, feel free to drop them
in the comments, and I’ll do my best to answer anything I can.
Otherwise, I’ll see you back here next week for another video.