The tax treatment of mutual funds is confusing. It’s very possible to make a ton of money on your funds and pay no tax.
But it’s just as easy to watch your account values drop and still face a painful tax liability at the end of the year. It has nothing to do with whether or not you withdraw money from your account.
How is that possible? It’s enough to drive any sane Pilgrim completely loco…
The tax structure seems wacky because there are 3 distinct events that trigger taxes:
- Capital Gains Distributions
- Realized Gains/Losses
Let’s talk about the first two items. Please keep in mind that mutual funds and ETFs are made up of lots of different stocks (and/or possibly bonds) within the portfolio.
During the year, the fund manager buys and sells securities. Some of these transactions result in gains and others in losses.
At the end of the year, if there is a net gain it is taxable.
If there is a loss, that loss can be used to offset other gains and some (limited) income.
If there is a gain and the investor reinvests those gains, it doesn’t matter –they are still taxable.
Of course, not all securities within the portfolio are sold. Some are held. And some of the securities which are held generate dividends and interest. That income is also taxable to the shareholder even if the investor reinvests it.
So you can see that if a fund manager sells off stocks for a gain but holds on to other stocks that later drop, your fund could actually drop in value at the end of the year and still leave you with a tax bill.
Likewise, your fund could go up in value because the securities held within the fund rise. But if the fund manager sells off stocks that are losers, you could have a tax loss even though your fund went up in value.
Either of these two things can happen even if you make no withdrawals from your account during the year.
Realized gains and losses are the third component that completes the mutual fund tax story.
If you buy a fund for $10 per share (for example) and sell it later for $12 a share, you’ll have a taxable gain.
Even if you turn around and re-invest that $12 in another mutual fund, you have a realized gain and you’ll pay tax on it.
Keep in mind that even though you sometimes pay tax on money you didn’t actually receive (capital gains distributions and dividends) those taxable events increase your cost basis.
This is important because when you ultimately sell the fund, the realized gains you recognized along the way help to reduce the taxable gain you report when you sell the fund once and for all.
Mutual fund taxation seems complicated but it really isn’t that bad if you break it down into these three elements.
Are you still befuddled by mutual fund tax? What other questions do you have?