Why Paying Capital Gains Taxes on Your Mutual Funds Isn't So Bad

It's all about how mutual funds are structured.

How can a fund that loses money generate a tax notice saying that it made money? It seems bizarre, but this is not unusual. In fact, having to pay capital gains taxes on an investment that has lost money is the most common complaint of mutual fund shareholders. But let me assure you: It's not as bad as you may think.

Let's start with an explanation of how capital gains taxes work. Say you invest $10,000 in a stock and it rises to $30,000. If you don't sell the stock, there is no tax. But if you do sell the stock, you have to pay a tax on the profit. This profit is called a "capital gain." You can delay this tax for years — even decades — by holding onto your shares, because you don't pay the capital gains tax until you sell (assuming the asset appreciated).

Now, let's see how this tax rule applies to mutual funds. You buy shares of a fund and the fund, in turn, buys stocks. If you sell your shares of the fund for a profit, you incur capital gains, just as if you had sold shares of stock (as in the paragraph above).

But say you keep your shares. No taxes, right? Not necessarily.

Why? Because the fund might sell some of the stock it owns. If the fund does this, the fund incurs a capital gain. And since you are the real owner of the fund, you are the one who has to pay the taxes. That's why the fund distributes Form 1099-DIV to you; this form reveals your share of the capital gains incurred.

That's the key point: If the fund sells shares of any of the stocks it owns, those sales trigger the capital gain — even though you have not sold any of your shares of the fund. But how can a fund incur a capital gain if it has lost money? Say you invest in a fund that's 10 years old. You pay $10 for each share. At the end of the year, your fund's share price is only $8 — meaning you've lost money. But soon after, you receive Form 1099-DIV in the mail declaring that you have capital gains of several thousand dollars. How can this be?

It's simple: Even though you bought shares of the fund for $10 per share, the fund itself owns stocks that it purchased many years ago. It has now sold some of those stocks for a profit. Thus, even though you didn't enjoy that profit, the fund you own did, and, as a shareholder, you must now pay your share of the taxes on that capital gain.

This certainly doesn't seem fair.

Now here's the good news. When you sell your shares in the fund, the tax you will be required to pay at that time will be lower than it otherwise would have been because you have, in essence, prepaid your tax. And if you sell your fund for a loss, you'll actually get a refund for the tax you already paid.

In other words, mutual fund shareholders pay a little bit of their capital gains taxes each year, whereas stock investors pay all their taxes at one time. Some people argue that stock investors have the advantage because, by delaying the tax, their money can grow faster.

But this isn't necessarily true since most fund investors reinvest their capital gains distributions into more shares, and this enables them to compound their growth more effectively than stock investors can.

Furthermore, when it does come time to pay that tax, fund investors happily discover that their tax bill is quite small, because they've already paid some or most of the taxes due. (In fact, when our clients sell a fund they've owned for years, it's not uncommon to see them sell the fund for a profit, yet owe nothing in taxes!)

So, don't let mutual fund taxes annoy you too much. Remember: There are worse things than not paying taxes...like not having any money!

This material was prepared for informational and/or educational purposes only. Neither Edelman Financial, LLC, nor its affiliates offer tax or legal advice. Be sure to consult with a qualified tax or legal professional regarding the best options for your particular circumstances.

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