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: