We Need to Talk About RETURN OF CAPITAL (Dividend Red Flag?) - YouTube

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.