Market Analysis

A Heads-Up On Mutual Fund Tax Bills

Did you get an unexpected mutual fund tax bill this year? Did it sting? Then don’t miss our new video.


Video Transcript

Hello, and thanks for tuning into the MarketMinder Minute! Today, we’re going to talk about surprises. Not the good kind, like a surprise party or finding a 20 dollar bill in your jeans. Rather, the bad kind: The unexpected tax bill many mutual fund investors receive each year.

This is a capital gains tax bill. Some investors expect one—they’ve probably sold some shares and know Uncle Sam will come calling. But lots of fund investors get bills when they never even sold a share! Why is this? Well, when a fund sells shares for a profit, they are required by law to distribute those gains to shareholders. These payments are called capital gains distributions, and they come with capital gains taxes. Here’s the kicker: Your share of the profits is based on how much of the fund you own. How long you’ve owned it doesn’t matter. That’s where the surprise comes from.

Here’s how it works. According to The Wall Street Journal, a certain mutual fund with a total market value of $260 million dollars will distribute gains worth over a third of its value to shareholders this year. They realized hefty long-term gains when they made some portfolio shifts, and didn’t have many losses to offset them—normal, this far into a bull market. If you have a $100,000 stake in this fund, you’ll probably get a capital gains distribution around $33,000. Presuming a long-term capital gains tax rate of 15%, that’s a $4,950 tax bill. Higher income earners could pay almost 9 percent more.

If you bought the fund several years ago and held it, you probably won’t mind. You watched the holdings run up while you owned the fund, and they probably feel like your gains. But if you bought it a year ago, it probably shocks and stings. You weren’t around while all those stocks were running up, and now you have to pay taxes on them? Your tax burden is just the same as a long-term shareholder? Ouch!

Likewise, the taxes surprise folks who simply bought into the fund and took no other action. In the eyes of the IRS, you benefit whenever the mutual fund sells shares at a profit. Taxes could even apply in a year your investment’s value declined. Another fund cited by The Wall Street Journal is kicking off $9 per share in long-term gains this year—again, about a third of its Net Asset Value. Its trailing 1-year total return is -0.6%. Big tax bills on unrealized losses aren’t fun.

Now, these examples, though real, are extreme—most mutual funds will distribute a much smaller portion of their value each year. Nonetheless, the lesson applies across the mutual fund universe: Capital gains taxes can be counterintuitive and surprising.

Keep in mind that mutual funds held in tax-deferred accounts like IRAs and 401(k)s aren’t subject to capital gains taxes. And there are good reasons for smaller investors to hold mutual funds, like instant diversification. But the costs can add up: One recent study of over 350 mutual funds found that on average, taxes reduced returns by 1.75 percentage points each year. On a hypothetical million-dollar investment that would otherwise grow at 8% a year for two decades, this cuts your returns by nearly $1.3 million. So if you are a larger investor and your mutual funds are taxable, you may want to consider individual securities as a more efficient alternative.