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It can be difficult to choose between Distributing Funds and Accumulating Funds when you need to choose two funds. And the problem is also the same when you need to compare two Exchange Traded Funds (ETFs). At first, it was not clear for me which one was better when I started designing my portfolio. Now, I always prefer Distributing ETFs.
Most shares pay a dividend to its shareholders. If you hold shares of a company paying a dividend, you will receive cash dividends several times each year. Since a fund is holding many shares, every fund will receive dividends. Once a fund receives a dividend, it will have to give it back to the real shareholders: you!
There are two ways for a fund to give back the dividends back to the investors. First, it can give back the money directly to the shareholders. This is a Distributing Fund, also called an Income Fund. Or, it can reinvest directly the dividends into the funds, hence increasing its value. This is an Accumulating Fund or a Growth Fund.
Whether you talk about funds or Exchange Traded Funds (ETFs) is exactly the same in this context. A Distributing ETF is simply a Distributing Fund traded on the stock market.
In this post, we are going to go over the differences between Distributing Funds and Accumulating Funds.
Now, capital gains and dividends are often taxed differently depending on which country you are in.
In the United States, you will pay taxes on capital gains and on dividends. They are both taxed at different rates unless you hold securities for less than a year. On the other hand, in Switzerland, capital gains are not taxed for private investors. And dividends are taxed as standard income, at your marginal tax rate. Let’s start to see the difference between the two types of funds with Swiss taxes.
Now there is a myth saying that you will not pay taxes on the dividends issued by accumulating funds. This is wrong! You will pay exactly the same amount of taxes regardless if you get the dividend or if it reinvested directly into the fund.
In Switzerland, accumulating funds are considered to have a virtual dividend. And they will be taxed as if they distributed this virtual dividend. The Swiss Tax Authority is keeping track of some ETFs in the ICTAX system. They will use this system to find out the dividends of your ETFs. If your ETF is not in this list, you can ask for it to be added to the list by contacting them. If your Accumulating ETF is not in the list and you do not ask for it to be added, your full capital gains are going to be taxed as income!
So, from a tax point of view, there is no advantage to either type of fund. However, it is easier, in Switzerland, to declare dividends than virtual dividends since you are sure you will be taxed on exactly what you received.
Taxes in other countries
For other countries, it depends on the tax system. In the United States, all the dividends are withheld at the source, so there is no difference. For instance, I know that in the United Kingdom it is also easier to work with distributing funds. On the other hand, in Belgium, it is more efficient to get an accumulating fund. Indeed, dividends are taxed on distributing funds and an accumulating fund allows to bypass this tax. And in Germany, you will save money by having a distributing fund.
Therefore, it is very important to know your tax system. For most people, it is not an interesting subject. However, if you want to save money on taxes, you should know the details of your country taxes.
In many countries, dividends are withheld by the country. This is the case in the United States, the country where most of the world stock market value is. So you will probably have some U.S. securities in your portfolio. If these securities are paying a dividend, some of it will be withheld by the U.S. Internal Revenue Service (IRS). 30% will be withheld for U.S. citizens and 15% for citizens of a country with a tax treaty with the U.S.
Once again, there are no differences between a distributing fund or an accumulating fund for this case. In Switzerland, in both cases, you will be able to declare the withholding with a DA-1 form in your tax declaration. That means that the withheld money will be counted towards what you are already paid in taxes.
For Swiss securities, this is also exactly the same. If you live in Switzerland, it is likely that you have Swiss securities. If they pay a dividend, 35% will be withheld by the tax authorities. But, the dividends for the accumulating will not be withheld for you but will be taxed in the same way.
When you buy or sell shares of a fund in your broker, you will have to pay some fees for the transaction. For some mutual funds that you directly own from your bank, it may be free to sell and buy shares.
If you have a Distributing Fund and you want to reinvest the dividends, you will have to pay some transaction fees to do it.
However, it is not as bad as it sounds. If you are in the accumulation phase, you will invest almost every month. At this time, you can simply invest the dividends with the new capital. And if you are early retired, you are going to use the dividends anyway.
The fees of a fund, its Total Expense Ratio (TER) is something very important when you compare two funds. And sometimes, there is a significant difference in fees between distributing and accumulating funds.
Indeed, sometimes distributing funds have higher fees than the accumulating funds. This is especially true for European Funds by iShares. A lot of their accumulating are more expensive than their distributing funds, for the same index. For instance, for the MSCI World index, iShares offer two funds in Europe:
- iShares Core MSCI World UCITS ETF (Acc) with a TER of 0.2%
- iShares MSCI World UCITS ETF (Dist) with a TER of 0.5%
The distributing fund is more than twice more expensive than the accumulating fund. This is a huge difference! Fortunately, there are better funds from other providers. However, if I had to choose between these two, I would use an accumulating fund for once.
Comparing two funds that have different dividend distribution policy is very difficult. If you directly compare the performance of an accumulating fund and a distributing fund of the same index with the same fees, the performance of the accumulating should be better in the long-run.
This is logical since the dividends are reinvested directly and are compounding over time. But this does not mean that an accumulating fund is performing any better than a distributing fund. Both types of funds have the same performance. This just means it is more difficult to compare them. In the case of the distributing fund, you will also have some amount of cash that you can use. Of course, if you splurge the dividends, you will be poorer than if you had the accumulating fund. But if you reinvest them., you should have exactly the same amount in the end.
In practice, you should be fine. Most ETF comparison platforms are showing you the performance as if the dividends were reinvested into the fund. For instance, this is what justetf does. This makes it possible to compare the performance of two funds with different distribution policy.
The big practical difference between accumulating funds and distributing funds is the inconvenience. Accumulating Funds are much lazier than Distributing Funds. You do not need to do anything with the dividends, they are directly reinvested into the funds.
On the other hand, if you have distributing funds, you will have to do something with the dividends that are sleeping as cash in your account. That means you will have to invest it back into one of your funds.
I do not think it is too bad. At most, you will receive one dividend from each of your funds each month. And it is much more likely that you receive one dividend per fund per quarter since most big funds are paying dividends only each quarter.
Since you should invest every month anyway, it should not be an issue to make a slightly bigger trade. And, we have already seen that for filling the tax declaration, it is generally more convenient to have a distributing fund.
When you have several funds in your portfolio, you may want to periodically rebalance the funds. That means that if one fund is performing worse, you will need to buy more shares of it to bring the balance back to your target allocation. On the contrary, is one fund is performing really good, you may want to stop investing in it or even sell some shares until your allocation is back to normal.
Receiving the dividends can give you an edge for rebalancing. Since you have extra cash at hand, you can invest it based on where your allocation is out of balance. That means that the dividends from your most performing fund could be reinvested in the worst performing one, bringing back balance. Distributed Dividends can help you rebalance!
Now, let’s go over the main difference between Distributing Funds and Accumulating Funds. Whether you hold one or the other can make a large difference when you reach Financial Independence.
If you are financially independent and live on your net worth, you will need to use your principal to cover your expenses. For the sake of the example, let’s say you need 4% of your principal to cover your expenses. And let’s say that you get 2% dividends from your funds.
If you have only Accumulating Funds, you will need to sell 4% of your principal every year. All your expenses are going to get covered by selling your funds. If you have Distributing Funds, you can cover half of your expenses by selling the funds and half of your expenses using the dividends.
There are two differences here. First, with Accumulating Funds, you will pay more transactions fees since you are going to have to sell more shares. And receiving dividends from a fund is free but selling some shares is not! But most importantly, you will have much more capital gains. In fact, you will not have any income but only capital gains.
In some countries, this is not so bad. But in Switzerland, capital gains are not taxed unless you are considered a professional investor. And you are a professional investor if capital gains are more than 50% of your income. Therefore, to avoid taxes on that, you need your dividends to cover at least 50% of your income. This is very important. And this makes it essential to hold distributing funds in Switzerland!
If you are not in Switzerland, it will depend on your taxation system. But in most countries, it is better to get dividends than to get capital gains. And therefore, in most countries, it is better to hold distributing funds rather than accumulating funds!
Overall, Distributing Funds are superior to Accumulating Funds. They will be much more useful once you are financially independent and ready to retire. You will need cash to cover your expenses. And the dividends are going to do exactly that. And they are generally more convenient from a tax point of view. They can also help you rebalance your portfolio more efficiently.
Contrary to some popular belief, accumulating funds are not more tax-efficient than distributing funds. You will pay the same taxes regardless of which you use. And in most countries, it is easier to declare dividends for a distributing fund than for an accumulating fund.
The only advantage of an accumulating fund is the convenience it offers. However, I believe that this convenience is a bit too lazy. You would be better off investing the dividends according to your allocation rather than blindly allocating it to each fund that generates them.
For all these reasons, I strongly believe that distributing funds are a much better option than accumulating funds. When I compare index funds, I generally only consider distributing funds. Only when there is no good distributing fund available for an index, will I consider accumulating funds.
Now, this stands true for Switzerland. In some other countries, it will not be true. In Belgium, it is better to hold accumulating funds. On the other hand, in Germany, it is also better to hold distributing funds. And in the United States, it makes no difference. Therefore, it is very important that you know the details of your tax system if you want to save money!
To learn more about funds, read how to choose index funds and ETFs.
What about you? Which kind of fund do you prefer and why?