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Posted: Aug 13, 2007
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. (For more specifics on the actual evolution of the dividend payment
process, see Declaration, Ex-dividend And Record Date Defined.)
How does it work?
Suppose we have a company called Jack Russell Terriers Inc., which trades on
the Nasdaq under the truly appropriate symbol of "HYPER," and is currently
trading in the market for $10 per share. Due to the popularity of Jack Russell
Terriers, HYPER has had record earnings, so the board of directors decides to
declare a special extra dividend of $1 per share with a record date of Tuesday,
June 12, 2007. As you know, the ex-date will be two business days earlier, on
Friday, June 8. If you own the stock on Thursday, June 7, you will get the $1
dividend, because the stock is trading with (or "cum") dividend. If you wait to
own the stock on Friday June 8, you are not entitled to the $1 annual dividend.
Keep in mind that the purchase date and ownership dates differ. At this time,
the settlement date for marketable securities is three days. So, to own shares
on Thursday June 7, the actual trade must take place on Monday June 4. (For
additional information on the stock settlement procedure see The Nitty-Gritty
Of Executing A Trade.)
The Stock's Value
What will happen to the value of the stock between the close on Thursday and
the open on Friday? Well, if you think about it within the context of actual
value, this stock is truly worth $1 less on Friday June 8 that it was on
Thursday June 7. So, its price should drop by approximately this amount between
the close of business on Thursday, and the open of business on Friday. 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 for 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
Monday June 4 for settlement on Thursday June 7 at a price of $10 per share.
What happens? As you know, the ex-date is two business days before the date of
record - Tuesday June 12. The stock will go ex-dividend (trade without
entitlement to the dividend payment) on Friday June 8, 2007. Bob owns the stock
on Thursday June 7, so 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 June 13, 2007 (dividend checks
are mailed or electronically transferred out the day after the record date).
When the stock goes ex-dividend on Friday June 8, 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).
Watch: Dividend
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 taxes are deferred until he withdraws his
money or, if he makes his purchase in a Roth IRA, 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 Thursday June 7
(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.
Additional Considerations
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. (To read more on this subject, see Selling Losing Securities For A Tax
Advantage.)
Concluding Though
It's not what you earn - it's what you keep - that really matters. Being
mindful of these ex-dividend circumstances should help you keep more of your
hard-earned dollars in your pocket and out of Uncle Sam's coffer.
by Helen Simon