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 tax on mutual funds that have lost money is the most common complaint of shareholders. But we can assure you: It’s not as bad as you may think.
As an example, say you invest $10,000 in a stock and it rises to $30,000. As you know, 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, or “capital gain.” You can delay this tax for years – even decades – by holding onto your shares, because you don’t pay capital gains tax until you sell (assuming the asset appreciated).
This tax rule applies a little bit differently 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 the stock (as in the paragraph above).
But keeping your shares in the fund doesn’t necessarily mean no taxes. 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 capital gains tax on the mutual fund. That’s why the fund distributes Form 1099-DIV to reveal 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?
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.
Now here’s why paying capital gains tax on mutual funds isn’t so bad. 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.)
While it may be a nuisance to pay capital gains tax on your mutual funds in the short term, we here at Edelman Financial Engines focus on the long-term strategy. Our advisors are always willing to have a conversation with you to determine the best wealth management strategy for your situation.
Neither Edelman Financial Engines, a division of Financial Engines Advisors L.L.C., nor its affiliates offer tax or legal advice. Interested parties are strongly encouraged to seek advice from qualified tax and/or legal experts regarding the best options for your particular circumstances.