Beware Mutual Fund Owners – Here Comes the Tax Man

Many people still invest money in mutual funds held in their taxable accounts.  Mutual funds give investors the opportunity to pool money with others and own securities such as stocks, bonds and so forth. A more recent investment type has surfaced in the last decade called Exchange Traded Funds (ETF’s).

So what is the issue with the “tax man”? Normally in December Mutual Funds make distributions to their shareholders that can be quite a tax surprise. Let’s say that you own 1,000 shares of a well-known equity fund that currently trades for $50/share. In mid-December the fund declares a $2/share distribution classified as capital gains. In December you elect to get this distribution as cash in your account instead of additional shares. On the distribution date the mutual fund share price (NAV) will drop to $48, representing the distribution and you will get $2,000 in your cash account.

Now comes the surprise, you have to pay capital gains tax on the $2,000 even though you never sold any of your mutual fund shares. Now let’s add fuel to the fire, you actually bought these shares at $100/share and this year you lost $50,000 in the value of your fund, yet still owe taxes.

Tax Man

That’s how it works with mutual funds. This happens because mutual funds must periodically sell shares to fund investors who sell their mutual fund shares.

There is another way to get the same benefit, switch from mutual funds to ETF’s. ETF’s act just like stocks from a tax point of view. If you don’t sell them you don’t have any capital gains! No December surprises. ETF’s have many other advantages for all types of investors.

Just Google ETF’s and read about the advantages.

BTW, if you act quickly you can sell your mutual fund before the distribution date and save on taxes. Many mutual funds have already posted their expected “distributions” on their web site.