John Hancock Diversified Income Fund: Tax Nuances and the Sustainability of Its Steady Payouts

The John Hancock Diversified Income Fund (NYSE: HEQ) has long been a favorite among income-seeking investors, thanks to its managed distribution plan that guarantees a fixed quarterly payout of $0.25 per share. But behind this predictable income stream lies a complex breakdown of distribution sources that demands scrutiny—particularly for those focused on tax efficiency and long-term capital preservation. Let's dissect the fund's latest Section 19(a) Notice to assess its tax implications and the sustainability of its payouts.

Breaking Down the Distribution: A Reliance on Return of Capital

The March 2025 distribution, like its predecessors, is split into two primary components: 53% net investment income and 47% return of capital or other capital sources. This structure has remained consistent year-to-date, with no contributions from short- or long-term capital gains. While net investment income (primarily dividends and interest) is a stable source, the return of capital portion raises critical questions.

Return of capital distributions reduce your adjusted cost basis in the fund, which can lead to taxable capital gains in the future if the fund's net asset value (NAV) doesn't grow sufficiently to offset this reduction. Over time, this could erode your principal, especially if the fund continues to rely on this mechanism to meet its fixed payout.

Tax Implications: A Double-Edged Sword

The fund's distribution structure creates a trade-off between immediate income and deferred tax liabilities. Here's how it breaks down for investors:
- Net Investment Income (53%): Taxed as ordinary income in the year received.
- Return of Capital (47%): Not taxed immediately but reduces your cost basis. If your basis drops to zero, future distributions become capital gains, taxed at lower long-term rates—assuming the fund's NAV hasn't declined.

The fund explicitly warns that return of capital does not reflect performance, and shareholders must await their annual Form 1099-DIV for precise tax reporting. For retirees or those in high tax brackets, this structure may complicate cash flow planning, as the tax hit could be delayed but unavoidable.

Is the Managed Distribution Plan Sustainable?

The fund's managed distribution plan guarantees $0.25 per share quarterly, regardless of underlying performance—a feature many income investors value. However, sustainability hinges on two factors:
1. Fund Performance: The 7.78% average annual total return over five years (as of Feb. 28, 2025) suggests the fund has historically generated growth to support payouts. But the 3.44% cumulative return through February 2025 hints at recent headwinds.
2. NAV Trends: A persistent return of capital could eventually pressure the fund's NAV. If the fund's assets under management shrink while payouts remain fixed, investors may face dilution.

Investment Considerations for Income Seekers

• Pros: Steady income, low volatility profile (given its focus on income-generating assets), and a distribution rate of 8.31% (as of Feb. 28, 2025) that outpaces many bond alternatives.
• Cons: Tax complexity, reliance on return of capital, and the risk of NAV erosion if performance falters.

Final Take: A Fund for the Disciplined Income Investor

HEQ remains a viable option for those prioritizing predictable cash flow over tax simplicity. However, investors must proceed with eyes wide open:
- Tax Management: Hold the fund in tax-advantaged accounts (e.g., IRAs) to minimize the impact of ordinary income taxes on the net investment portion.
- Monitor NAV: Track HEQ's NAV growth relative to its distribution rate. A persistent gap could signal unsustainable payouts.
- Diversify: Pair HEQ with other income sources (e.g., dividend stocks or Treasury bonds) to balance tax treatments and reduce reliance on return of capital structures.

In a low-yield environment, HEQ's 8.31% distribution rate is tempting, but its return of capital component underscores the need for vigilance. For the right investor—one who can handle tax complexity and has a long-term horizon—this fund could still deliver. Just don't mistake the steady payout for proof of performance.

Disclosure: Always consult a tax advisor before investing in funds with significant return of capital components.