Here’s a strategy that could save you hundreds or thousands of dollars if you own mutual funds. (You’re welcome…)
Ah, the mutual fund.
They seem just like the first few minutes of a horror film. Diversification, competitive returns, professional management….everything is just perfect, isn’t it?
…but there’s trouble lurking around the corner.
In the horror flick you know danger is coming. Hell, you walked into the theater specifically to see it! With mutual funds, many people don’t see it until too late.
The big, ugly truth about mutual funds, and this year in particular, is that you might have a big tax bill waiting for you on tax filing day next year, even if you don’t sell your fund.
Huh? How’s that possible?
To understand how, you have to know how a mutual fund works.
How Mutual Funds Tax Investors
When you buy a fund, your money goes into a pot that buys stocks. Many of these stocks were actually purchased years ago….you just now own a share of them. Think about the constant buying and selling that funds do. While it’s easy to know how much a person has made individually from a fund, how is the fund able to lay out the tax bill for the underlying investments?
As an example…..a fund purchased MSFT for $22. They later sell it for $40. You own the fund but didn’t cash out. A tax is due on the $18 gain, but how do they decide who pays it?
If you think about it, there’s only one fair way (and it totally isn’t fair).
They tax the people who own the fund near the end of each year.
Funds pay the tax by establishing a tax distribution date. It’ll look like you make money, but no cash actually comes to you. Instead, they’re just distributing the tax hit among all of the shareholders.
It’s Important For You to Act
If you own a mutual fund outside of a tax shelter, find out if it’s going to have a tax distribution this year. It’s public information….you just need to visit the mutual fund company website or call their toll free number.
You can also find out exactly what day the tax will be assigned. You can sell the fund the day before and avoid the tax.
You Might Not Want To Sell
If you’re going to have a monster tax by selling or by holding, consider your options. While on one hand it might be a great time to exit, you’ll end up with a double whammy by selling. You’ll avoid the tax on the fund but you’ll trigger a tax when you sell.
On the other hand, if you were thinking of getting out anyway, sell before the tax hit happens to avoid unnecessary taxes.
A couple of years ago a reader accused me of tax evasion, saying that this strategy is unethical because it avoids taxes. I want to be clear: this is public information and the strategy is legal. People with money and competent advisors do this without thinking about it. It’s your job to understand tax law and to react appropriately. If you don’t like the loophole write to your congressman.
….I’d just write them AFTER you’ve saved yourself a bunch of money.
Want more information? Check out this article from Time: Big Tax Bill Looms for Mutual Fund Investors
“It’ll look like you make money, but no cash actually comes to you. Instead, they’re just distributing the tax hit among all of the shareholders.” Do you really mean NO CASH…because I understood it as: you get that money, but you owe the tax on that distribution….that’s not NO cash, that’s 85% assuming it’s long term cap gains.
Nope. You’ll see a distribution on paper which is just a rearranging of the chairs. No money will enter your hand…..once you get your paper gain, that’s taxed.
Yeah, if you’re thinking, “That’s ugly,” you’re right on.
I have most of my investment in tax shelters so this hasn’t been an issue. And if I invest in mutual funds outside of an IRA or 401k, I’d stick with index funds which don’t sell stocks often.
You’re right, but with mutual funds you still have unrealized gains that’ll need to be disposed of at shareholder expense. Not as big a tax, but still bigger than an ETF.