You may get this tax bill, despite not making or losing money in that mutual fund this year!
How could this happen?
Mutual funds managers sell and buy securities all year long. With every sale they either make or lose money. These gains and losses get netted to determine if there is a net gain or loss within the fund due to these sales. If there is a net gain, the fund by rule has to pay these out to their investors (you). In a taxable account, you will receive a 1099 showing the amount of gains you need to report on your tax return. You pay tax on the gain whether you reinvest the money or are sent a check. What you will see below is that many popular mutual funds are not particularly tax savvy. This could be because a lot of their investors own these popular mutual funds in their 401k or IRA and the distributions are not taxable.
Did you know that you could actually lose money in your mutual fund and still be stuck with these taxable gains? You need to understand that when you buy into a mutual fund you are buying into an existing portfolio of holdings and all the shares have a “cost” of something other than what it was the day you bought in.
For simplicity purposes, let’s imagine a one stock portfolio and an exaggerated example:
Let’s say you bought a fictitious “Twitter Fund”. You invested in the fund in April of 2015 at a price of $48. The fund had bought Twitter stock in 2014 at $40 per share and sold it in 2015 for $50 per share. Now Twitter is selling for around 24 per share so your account has dropped by 50%. Since there was a net gain from the only sale in the fund it would be distributed and taxed. Despite your account being significantly down in value you owe tax on the net capital gain from sale within the fund.
Due to the long-term run up in stock prices many stock mutual funds own stocks they bought a long time ago for much less than they are worth today. When they sell these positions, it may leave shareholders with more taxable gains.
One potential solution is to seek investments that focus more on after-tax returns (tax-managed). It’s not what you make, but what you keep after tax that counts.
Here are some of the actual and projected capital gain pay out coming later this month.
Mutual Fund Name, 2015 Capital Gain Estimate, Taxable Gain Per $100000
Growth Fund of America, 7-8%, $7000-$8000
Investment Company of America, 5-7%, $5000-$7000
Washington Mutual, 3-5%, $3000-$5000
Vanguard Growth & Income, 5.33%, $5330
Vanguard Windsor, 5.98%, $5980
Vanguard U.S. Growth, 7.98%, $7980
Fidelity Advisor Large Cap, 2.48%, $2480
Fidelity Capital Appreciation, 11.37%, $11370
Fidelity Contrafund, 4.16%, $4160
Russel U.S Large Cap Growth, 0%, $0
SEI Tax-Managed Large Cap, 0%, $0