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Basics of Mutual Fund Taxation

Timothy GroveJune 11, 2015

Investments

At first glance, it would seem that, at its most basic level, the tax treatment of capital gains is fairly straightforward.  If one sells an asset for a sum greater than its original purchase price, the profit is taxable as a capital gain in the tax year in which the gain was realized.  The gain or loss is classified as short term if the asset was held less than a year, or long term if held longer than a year.  If the asset is sold for less than the original purchase price, a capital loss (either short or long term) results; this loss can then be used to offset capital gains and ordinary income up to $3,000.  What is key is that capital gains and losses have no tax impact until they are actually realized; that is, the asset must be sold in order for there to be a tax impact.  This gives taxpayers a great deal of control and flexibility as it enables them to determine when they will pay tax on a gain (or when to realize losses so that they may be used to maximum benefit).  The taxpayer can also defer tax on unrealized gains indefinitely if so desired by simply holding the asset. If a taxpayer realizes a loss on the sale of an asset that cannot be fully utilized in the year of sale there is also no expiration on capital losses that are carried forward to use in future tax years.

Unfortunately, for holders of open-ended, or “40 Act” mutual funds in taxable accounts, things are not quite so simple.  In addition to being taxed on dividend and interest income that is generated by mutual funds, a shareholder can, and often does, find himself or herself liable for capital gains taxes even though he or she did not sell any shares of the fund in that tax year.  What’s worse is that this can (and sometimes does) occur even if the net asset value of the fund declined during the year.  The reason for these tax implications is that mutual funds are structured as “pass through” entities.  In order to avoid being taxed themselves on interest and dividend income and net realized capital gains from the fund’s underlying holdings, mutual funds must distribute nearly all of the dividend and interest income and net realized capital gains to their shareholders, who are then responsible for the tax on those distributions.

When the managers of a mutual fund sell the stocks or bonds in the fund’s underlying portfolio, capital gains and losses are realized.  At least once a year, the fund must distribute any net realized capital gains to the fund’s shareholders; these distributions are usually made at the end of the calendar year.  This gives rise to yet another possible unpleasant tax surprise -if shares of a mutual fund are bought right before a capital gain distribution occurs the shareholder will be taxed on gains from which he or she did not even benefit!  Net realized losses in a mutual fund’s underlying portfolio cannot be distributed to shareholders.  These losses stay on the fund’s books and are carried forward to offset future realized gains, thus potentially reducing future capital gains distributions.

Another tax bane of the mutual fund shareholder is the treatment of short term capital gain distributions.  Like any realized short term capital gain, these are taxed at ordinary income rates instead of the lower long-term capital gains rate.  But unlike short term gains realized  by the direct sale of an asset by the taxpayer, short term capital gains distributions from mutual funds cannot be cancelled out or offset by the taxpayer through the use of realized capital losses.

So what is a mutual fund shareholder to do?  The most important rule is not to buy a mutual fund in a taxable account just before it is scheduled to make a capital gains distribution.  One must be particularly careful of this at year end; funds usually make an announcement near the end of the year regarding the timing and amount of anticipated distributions.

Investors should also make full use of tax-sheltered retirement accounts such as IRAs and 401(k) plans as distributions made by funds held in these accounts are not taxed until they are withdrawn, or, in the case of Roth IRAs, are not taxed at all.

Another way to minimize the likelihood of unwanted capital gains distributions is to use funds that have low turnover ratios in taxable accounts.  Turnover is expressed as a percentage of the fund’s underlying portfolio that is typically replaced in a year.  So funds with high turnover are more likely to have capital gains distributions.  Index funds and other funds that utilize “passive” management (such as those offered by Dimensional Fund Advisors, or DFA) by their nature tend to have relatively low turnover.  While “actively managed” funds usually tend to have higher turnovers, there are some funds that have very low turnover ratios and are thus suitable for taxable accounts.  A high turnover ratio in and of itself is not a reason to avoid a fund if it has had good long term performance and is otherwise suitable, but such funds should generally be used only in tax-sheltered retirement accounts such as IRAs.

Another strategy is to hold the bond portion of a portfolio in taxable accounts and the stock mutual fund portion in tax-sheltered retirement accounts, as bond funds generally do not have the high amount of capital gains distributions that stock funds do.

Lawmakers in Congress have come under pressure in recent years to better align the tax treatment of mutual funds with that of directly-held stock and bond portfolios and thus mitigate the disadvantages that mutual fund shareholders face.  These disadvantages were brought into sharp focus after the bursting of the tech bubble in 2000 and the housing bubble in 2008, where shareholders were hit with the taxes on capital gain distributions in spite of the fact that their mutual funds suffered steep losses.  This was due in large part because fund managers had to sell holdings to meet heavy redemption requests.  One proposal that has been floated is to defer the tax on capital gains distributions that are reinvested in shares of the same fund until those shares are sold.  While some progress has been made (mutual funds can now carry losses forward indefinitely just as individuals can; previously the losses expired after eight years), the feared loss of tax revenue has prevented lawmakers from enacting any significant legislation.

While tax considerations are important, investors should not “let the tax tail wag the dog” and focus so much on taxes that such factors as performance, asset allocation, and proper diversification fall by the wayside.  A fund that is tax-efficient but has poor returns may leave the investor with less after-tax return  than a fund that is less tax-efficient but has outstanding returns, even after the taxes are paid.

 

Sources

Article – Dreaded Short-Term Capital Gains Distributions

Article – How Mutual Funds Could Get a Lot Less Taxing

Article – FAQ about Taxation for Mutual Fund Investors

Investopedia – Mutual Fund Characteristics and Taxation

Article – Mutual Fund Tax Guide

Article – The Bright Side of Past Fund Losses

Article – Mutual Funds and Taxes

Article – The Tax Rules of Mutual Funds

Article – One Solution