Unit trust investing and compounding - query

bowlhead99

caper7 said:

I have M&G recovery fund Acc.
I get a tax voucher each year detailing my dividends which I declare for income tax even though I never actually receive the money. 

That's correct. The fund made income and allocated it to the owners of the fund, but you selected to use the accumulation class rather than the distributing class because you didn't want to physically receive the money. So, instead of reducing the value of the units and sending you the cash (as they do in the distributing income class), they instead kept the value of the units the same and kept the money so they could buy more shares of the underlying companies that the fund owns.  They still need to tell you about the income you made, for tax purposes, because it's still your income, you just chose not to physically receive it so it remains inside the fund units.

When you eventually sell out of the fund and calculate your capital gains tax, you are allowed to say that the income which was internally reinvested by the fund is a part of your total cost of buying the investment you have just sold (even though you didn't physically spend the cash on buying more shares yourself, because you didn't physically get sent the cash).  So the tax vouchers help you correctly figure out any dividend income tax and capital gains tax over the period of ownership.

It suddenly occurs to me that the number of units I have should be increasing instead, but they never have. 
Is that correct? 

It's correct for the number of units you hold to NOT increase, because you have not physically received any cash and have not asked them to issue any more units to you. They kept the cash and retained all the value of the allocated dividends within the units that you hold. So the units of this 'Accumulation' class are more valuable than the equivalent units of a 'Distributing Income' class of the same fund would be.

If I've understood the answers above, the dividends go back into the fund rather than in an increase in units for me, allowing the fund to buy more and be more valuable and in that way increasing the value of my capital.
Is this correct? 

Yep

caper7

@bowlhead99
Just spotted your reply, thanks as ever for the thoroughness of your posts. 
I'm clear on declaring the dividends for income tax which I have always done, however I might have misunderstood something regarding the cgt. 
I assumed that I simply subtracted the amount I paid for the investment (probate value when I inherited in this case) from the sale value, but you seem to indicate that the dividends are somehow part of the calculation. Are they? Surely they can't be income and capital? Or have I misunderstood what you wrote? (very possible!) 

AlanP_2

caper7 said:

@bowlhead99
Just spotted your reply, thanks as ever for the thoroughness of your posts. 
I'm clear on declaring the dividends for income tax which I have always done, however I might have misunderstood something regarding the cgt. 
I assumed that I simply subtracted the amount I paid for the investment (probate value when I inherited in this case) from the sale value, but you seem to indicate that the dividends are somehow part of the calculation. Are they? Surely they can't be income and capital? Or have I misunderstood what you wrote? (very possible!) 

You declare the dividends "received" as income, even though if you have an ACC fund you don't receive the cash , it is used to increase the value of each Unit you hold instead.

You don't then want to pay CGT on that increased Unit value, as it has been assessed for income tax already. therefore you adjust the value of a Unit downwards by the value of the dividends added to them over the time period to arrive at a net gain / loss compared to your purchase price.

If you just subtracted probate value (= purchase cost) from the sale value (that includes accumulated dividends) then you will more tax than you need to.

 

bowlhead99

caper7 said:

@bowlhead99
Just spotted your reply, thanks as ever for the thoroughness of your posts. 
I'm clear on declaring the dividends for income tax which I have always done, however I might have misunderstood something regarding the cgt. 
I assumed that I simply subtracted the amount I paid for the investment (probate value when I inherited in this case) from the sale value, but you seem to indicate that the dividends are somehow part of the calculation. Are they? Surely they can't be income and capital? Or have I misunderstood what you wrote? (very possible!) 

Basically if you imagine your probate value was £1000 and it was a distributing fund. You might get £100 of income over the course of a few years  which you could reinvest back into buying more units, so all the money is back in the fund and you'd have an allowable cost of £1100 for when you do the eventual capital gains calc. Then if you sell the whole lot for £2000, you'll have a capital gain of £900 ; that's the difference between the £2000 proceeds and the [£1000 probate value plus £100 own investment]. 
So over the course of the investment when walking away with £2000 having originally inherited something worth £1000, you'll have had £100 of dividends subject to income tax and £900 subject to capital gains tax.

Alternatively if you use accumulating units, you won't physically receive the £100 of income so you won't need to manually re-invest it, but your tax voucher says you 'got' it for income tax purposes, while you don't have any cash to show for it so you are considered to have re-invested it as far as your CGT calc is concerned.   Then when you sell the whole lot for £2000, you can deduct the £1000 probate value of what the investment was worth when it became yours, and you can also deduct your 'notionally reinvested' £100 of dividend.  So just like if you'd used distributing units you can say your total allowable cost is £1100 against the £2000 proceeds, for a £900 capital gain.  on top of the £100 of dividend income over the t

In that scenario, just like when using distributing income units, you'll find that over the course of the investment when walking away with £2000 having originally inherited something worth £1000, you'll have had £100 of dividends subject to income tax and £900 subject to capital gains tax.

caper7

@AlanP_2 @bowlhead99
Thank you both. 
Well this is all news to me and I'm very grateful for the heads up. 
So if I understand correctly: I add all dividends received from probate to sale to the original probate value and subtract that from the sale price to calculate my gain (or loss).
I really had no idea about this, luckily I haven't sold them already, though perhaps I should as a read a pretty scathing review of the fund on Hargreaves Landsdown, but that's a separate issue... 
Many thanks 

bowlhead99

caper7 said:

So if I understand correctly: I add all dividends received from probate to sale to the original probate value and subtract that from the sale price to calculate my gain (or loss).

Yes - assuming where you say all dividends received, we are still talking about that Acc fund where the dividends are allocated to your shares/units but not actually received by you, and the fund has internally reinvested them.