Mutual Fund Taxes
I am a bit tardy with this article. Or maybe I am right on time as we are approaching tax filing season. It is a quick summary of how you need to be careful with Mutual Funds in taxable accounts. The super short version is they can be a tax bomb waiting to go off regularly.
Quick background for you. I am referring to actively managed mutual funds in this article. This is where a team of fund managers are changing investment holdings within the mutual fund to achieve their goals. Most goals are to outperform a certain index, but there can be other goals.
Mutual funds as a whole are rather tax-inefficient investment products. There are various components to this, but I will focus on Capital Gains today.
Capital Gains are when mutual funds have sold assets that have increased in value from their original purchase price. This is a great problem. Except this can create an unexpected tax bill for the investor in the mutual fund.
Mutual funds hold lots and lots of different investments within one fund. Some go up in value and others go down. The selling and buying of investments within funds happens when investment managers rebalance, sell holdings they want to get rid of, add new holdings, or need to create cash for mutual fund investors wanting to redeem some of their investments for cash.
When mutual funds have down years they can create lots of losses that can be used to offset gains in the current year and/or future years. Eventually these losses get used up in cases like the last couple of years where the market has gone up so much. Unfortunately, this is when gains can no longer be absorbed within the mutual fund and have to be passed along to investors.
Toward the end of each year mutual funds report out their capital gains distribution plans. Investors get the head’s up that there may be a big distribution (aka – tax bill) coming their way. There is a database of capital gains distributions I follow with nearly 450 funds reported to this database last year. Of those, more than half planned distributions of at least 10%. Heck, a dozen funds had distributions in excess of 30%, which exceeds what the S&P500 did for the year.
Again, capital gains are a good problem. It usually means your investments have gone up, but this is not always the case. There are years when investments as a whole are down, but some mutual funds still cancel out capital gains. Talk about getting kicked when you are down.
Regardless, capital gains distributions out of mutual funds can be an unexpected and unfortunate tax bill. Again, mutual funds are not the most tax-efficient investment vehicles.
I am not saying to avoid mutual funds, but be careful what you own and in what types of accounts.
As always, this seems like a good place to stop. Hopefully you learned something new today. And if your current advisor is generating unnecessary tax bills for you, never hesitate to reach out to me for a conversation.