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Financial Planning Insights

Taxes on Mutual Funds

By The Chandler & Knowles Team | | 0

What Is a Mutual Fund?

A mutual fund is an account where you pay professionals to invest your funds in diversified holdings. Mutual fundsYou join a pool of investors who entrust their money to a fund manager, who makes the investment decisions. The portfolio manager is paid from the pool of money in the fund. 

Mutual funds can be an effective means for smaller investors in need of professional money management. They provide diversification that the average investor could not manage easily. Say you have $15,000 to invest and place it in a well-diversified mutual fund that manages 50 different stocks. You can sit back and watch the fund perform.

Another investor would have to do the expensive and cumbersome trading to buy just a few shares of stocks and look for promising bond funds. Add to the foregoing a broker’s commission of 6%, or $900, for the portfolio and at least $10 in commissions per trade. So, mutual funds spread out those costs among many investors, giving them access to more diversified and high-performing investments.

On the other hand, as mutual fund portfolios grow, scale constraints can cause mutual fund maintenance to be more expensive than trading independently. Mutual funds are typically sized for a restricted number of accounts serving moderate sized investments.

Mutual funds are taxed

When you hold shares in a taxable mutual fund, you pay regular income tax rates on fund distributions. Those taxes accrue whether you accept the earnings or—as usually occurs—plow them back into the mutual fund. Likewise, if you sell or roll over the entire fund, you are subject to capital gains tax on what the fund earned if you have owned the fund longer than one year.

The biggest tax disadvantage of a mutual fund come tax time is that at the end of the year during a down market. The value of the fund can shrink. However, dividends you received from the individual stocks within the fund are taxable. You are actually paying taxes on money you lost!

Each mutual fund owner receives an IRS Form 1099-DIV for each stock and bond account. The bottom line is that you add up all the money you earned in the mutual fund and you pay income tax on it. Unfortunately,  you could be liable for capital gains taxes in a mutual fund in a year where you sold no shares yourself—and, again!—even when the overall fund incurs a loss. You are in effect sharing the tax burden of every member of the fund.

Plan your tax load wisely

So, if you own a mutual plan, plan accordingly. Your yearly tax plan should consider that you may be paying more taxes, but you may not be realizing the immediate benefits of your mutual fund growth. You may be happy that your fund has grown, but you pay the fund maintenance and tax costs while you sit on the sidelines. 

If you’re looking for tax advice on mutual funds as well as any other retirement account, contact us.


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