This question came to me when I was reading The Dough Roller’s post about why do mutual funds close to new investors. Part of the post read:
…taxes for existing investors went up after a fund closed. Why? Because there was no longer an influx of new investors to share the tax burden.
Is it really possible for new investors to pay taxes for existing investor? Unfortunately, yes. I am sure none of us want to pay taxes for other people, but that’s exactly what we do when we invest in mutual funds outside of tax-sheltered accounts, like 401k, IRA, or 529 plan.
Photo via Wikipedia, text added by Pinyo
Let’s take a look at a fund I own that just distributed some serious money, T. Rowe Price Extended Equity Market Index (PEXMX). Let’s go through an example to demonstrate how it is possible for an investor to pay someone else’s taxes. Let’s assume an investor bought 1,000 shares of PEXMX for $18.15 per share on July 2, 2007.
In summary, the investment loses its value and the investor ended up paying taxes on the distribution.
Mutual funds trade underlying stocks throughout the year, and accumulates profits and losses. By law, funds have to distribute any taxable gains from investing to shareholders each year. This is why you can get hit with a big capital gains distribution, and subsequently the tax bill.
To top it off, you could be paying taxable gains for stocks that these funds bought years ago and sold for profit. This means that you didn’t get to enjoy the rise in value, but ended up paying taxes on the gain anyway.
Don’t invest in mutual funds outside of tax-sheltered account, instead use Exchange-Traded Funds (ETFs). ETFs are a lot more tax efficient than mutual funds, and still offer the same level of diversification.
More about mutual fund and taxes:
Great advice to buy ETFs to cut down on taxes. I think broad market based ETFs are the best bets.
If you have to buy mutual funds then at least try to avoid funds that have a high turnover which will add to the tax bill.
Finally – if you are making a large lump sum purchase – try to do it as early in the year as possible – at least that way you are paying your own taxes rather than someone else’s.
Mike
Thanks for the link!
I had been planning to open a non-retirement account with Fidelity to start investing in a couple of mutual funds I liked, but now I’m more convinced than ever that the money would be better off going into my existing ETFs. Mutual fund action will stay in my tax-advantaged retirement account.
Thank you for the post!
What about buying and selling mutual funds before capital gains?
Now that I think about it, you can’t really make much money that way, can you?
@FourPillars – Good advice regarding choosing funds with low turnover. Regarding buying toward the beginning of the year, that’s also a sound advice — but you can pay other people’s taxes still. I think a lot of funds are ticking time bombs. If there’s a large out flux that causes the manager to sell stocks, the distribution will get worse causing even more sell offs.
@Honest Dollar – No problem. I am of the same mind regarding mutual funds vs ETFs in taxable vs. tax-sheltered accounts.
@Matthew – You’re welcome.
@Mark – No, because you’ll end up paying short-term capital gains versus the cheaper long-term capital gains.
Pinyo – you are right – capital gains can build up over years. Another problem is a change in fund manager, a new manager might sell off a lot of old holdings thereby triggering cap gains.
Pretty hard to predict management change however.
Mike
@FourPillars – certainly.
I don’t own any mutual funds (no kidding!) but I’m confused.
Mutual Fund M buys stock X in 2000.
Joe buys M in 2003.
Bob buys M in 2005.
Joe sells M in 2005.
Fund M sells stock X at a profit in 2007.
I can see where M’s gain is distributed to Bob in 2007, and Bob pays taxes on it.
I don’t see where Bob is paying Joe’s – or anyone else’s – taxes. If Joe is actually in a loss position, he will “enjoy” a LT capital loss when he sells, thereby reducing his taxes.
@Minimum Wage – You’re surprising me more and more everyday
Good question.
“I don’t see where Bob is paying Joe’s – or anyone else’s – taxes.”
Since mutual fund is a type of co-ownership, when I buy a share of mutual fund, I am actually buying a tiny fraction of each underlying stocks. Underlying stocks that gained value benefited someone else before I bought into that ownership. Once the fund distribute capital gains, it’s akin to me paying other people taxes. Why? Because if we were talking about individual stocks, the person who enjoyed the gain is the one who pay taxes — this is not the case with mutual fund.