Hopefully you are aware that ETFs come in two flavours - distributing, where income such as company dividends and bond coupons are paid out to investors, and accumulating, where that same income is reinvested in the fund, on behalf of the investors. And you might be wondering which it is better to buy. As do I. And my opinion on this has recently changed, because of some things I’ve just learned. So I wanted to share those learnings. But first, a warning: I’m not a financial advisor, and you need to do your own research on this subject.
In the UK, there isn’t actually any difference in the way that income generated in accumulating vs distributing funds is taxed. Both sets of income are taxed when they arise (or a fixed period thereafter). For a distributing fund, the income is paid out to you, and you then pay income tax on that income, at a rate determined by your tax band but also the type of income: interest or dividend. But it’s pretty straight forward - you receive money, you pay tax on that money. Your broker should report those numbers to you in your end of tax-year report.
For an accumulating fund, the income isn’t paid out to you, but the fund nevertheless reports the income, as something called Excess Reportable Income (ERI), and you are expected to report and pay tax on it, again at a rate determined by the type of income (interest or dividend), as well as your tax band. The thing is, this income actually goes into the fund, so increases the value, and therefore the gains. Therefore, in order to not pay both income tax and capital gains tax on the same money, when you come to sell, you need to remove the ERI from the gains. So it’s actually quite complicated - you pay tax on money you haven’t yet received, and you then also have to account for this when computing your gains at the time of sale. To make it worse, some brokers, InvestEngine included, don’t report any of this to you in your annual tax report. It’s up to you to source all the figures, do all the calculations, and report it to HMRC. Side note: I now get AI to do all this for me.
However, there is another pitfall with accumulating funds, to do with timing buys and sales. You see, a distributing fund generally drops in value by the amount of income it pays out, at the moment of pay out. Of course, an accumulating fund doesn’t pay out, so its price doesn’t drop on the ERI period end date (which is the date that matters for attribution of the income). You could buy an accumulating fund the day before the ERI period end date, and sell the day after. You owned the shares on the period end date, so need to pay tax on the ERI. However, the ERI is income generated over the entire reporting period, which for most funds is a whole year. So you need to pay tax on a fund’s total annual income, whilst only holding it for a few days. In that situation you could easily owe more in tax than the entire gain you made on the stock. You could also do the inverse, and own the fund up until just before the reporting period end date, sell it, then buy back just after (don’t get me started on 30 day bed and breakfasting rules), so avoid having to report ERI. Suddenly you don’t owe tax on the income, and instead you’ll owe more in capital gains tax. Now these two scenarios are unusual, but they make clear that the timing of buys and sales of accumulating funds can make a difference. This is less the case with distributing funds - the gains are the gains you see, and the income is the money you actually received.
Update: AI has pointed out to me that these timing pitfalls do still exist with distributing funds. However, I believe they’re more transparent - you’re aware that you’ve received income but also suffered a capital loss. Also, the distributions are usually more frequent (quarterly or semi-annually) than the annual ERI reporting, so the impact of timings is reduced.
At this point you’re probably wondering what’s the point in accumulating funds. Firstly, many countries don’t tax this way, so tax residents of those countries don’t have the issues I describe above, and can benefit from converting income into capital gains (which is what accumulating funds do). Secondly, the issues I describe above aren’t relevant if you hold the funds in a tax-wrapper such as an ISA or SIPP. And, there are other marginal benefits to accumulating funds - dividends from the fund holdings are reinvested immediately, not when they finally get paid out to you, and you don’t lose the price spread by having to reinvest yourself either.
So my current view is this - in a SIPP or ISA, hold the accumulating version of a fund (if available), to benefit from the marginal gains they offer, but in a GIA, hold the distributing version (if available) to make reporting easier, only pay tax on money you actually receive, and reduce the pitfall of buys and sales timed poorly around ERI period end dates. What’s your view?