A Review of the Tax Implications of Investing in Mutual Funds (2024)

After-Tax vs. Pretax Returns: Which Matters?

When investing in mutual funds using a taxable brokerage firm account, you should look at what kind ofafter-taxreturns various funds have been earning. Use those figures as one factor when choosing between competing funds.

However, if you’re using a tax-advantaged retirement account — such as a traditional or Roth IRA, 401(k), SIMPLE or SEP — to hold mutual fund investments, you can focus strictly on each fund’spretaxreturns and ignore all the tax issues explained in the main article. With these accounts, you only owe taxes when you take withdrawals. Until then, gains, losses, dividends and interest that accumulate in your account have no tax impact, and, with a Roth IRA, the gains, dividends and interest can be permanently federal-income-tax-free if you only take tax-free qualifying distributions.

January 19, 2022

Mutual funds are an attractiveinvestment option, especially for people who are looking for a low-maintenance, long-term way to participate in the securities markets. These funds are managed by professionals who should be well-qualified to judge which securities are attractive bets. Mutual funds also make it easier to maintain a diversified portfolio, which can reduce risk and volatility over time.

But there are two major downsides. The first is the management fees the funds charge. The second is that, if you hold fund shares in a taxable brokerage account (not a tax-advantaged retirement account) you have limited control over taxes.

You control when you sell your shares in the fund and thus you can consider the tax consequences before making a decision to sell those shares. But there also can be tax consequences for you whenthe fundsells investments it’s holding. And the fund — not you — decides which of its investments will be sold and when. If sales the fund makes during the year result in an overallgain, you’ll receive a taxable dividend distribution, whether it’s wanted or not.

In fact, you can wind up owing taxes even if your fund shares havedeclinedin value. That happens when the fund sells securities that appreciated while it was holding them, but the price of the fund’s shares went down after you bought in. In the not-too-distant past, this scenario has occurred and created some negative tax results for fund investors.

In 2021, the markets were generally bullish, so many mutual fund investors could face unexpected tax consequences for the year. Here’s the full story on federal income tax angles for mutual fund investments held in taxable accounts.

Taxable Distributions

Mutual funds make taxable distributions because the Internal Revenue Code requires them to pass out as dividend distributions almost all of their income and gains earned during the year. Otherwise, the funds get hit with the corporate income tax.

The problem of unwanted taxable distributions is less of an issue for the following two types of funds:

Index funds.For the most part, index funds buy investments and then hold them. This approach tends to minimize taxable distributions.
Tax-managed funds.Also known as tax-efficient funds, tax-managed funds lean toward a buy-and-hold philosophy. When they do sell securities for gains, they usually try to offset the gains by selling some losers in the same year. This approach also minimizes taxable distributions.

In contrast, funds that actively churn their stock portfolios can generate significant annual distributions in a rising market. The tax implications of these payouts can be annoying enough, but it’s even worse when a large percentage comes from short-term gains. Distributions that arise from short-term gains are taxed at your regular federal rate, which currently can be as high as 37%. In addition, you may owe the 3.8% net investment income tax (NIIT) and, depending on where you live, state income tax.

On the other hand, funds that generally buy and hold their investments for longer than a year will pass out distributions that are mainly long-term gains taxed at a federal rate of no more than 20% under the current rules. However, the 3.8% NIIT and state income tax can still increase the tax bite.

Important:It’s possible that Congress will increase some federal tax rates for individuals. If so, 2021 rates will probably be unaffected, but 2022 rates could go up for some taxpayers. We’ll keep you up to date on any changes.

Unexpected Tax Consequences

As with regular stock shares, you can make outright sales of mutual fund shares. When you sell shares outright, you know that you’ve triggered a capital gain or loss for tax purposes and whether it’s a short- or long-term one.

However, mutual fund companies allow investors to make other transactions that are also treated as taxable sales. These transactions provide added convenience, as long as you understand the tax ramifications. The following two common transactions can result in unanticipated mutual fund share sales:

Check-writing privileges.Some funds allow you to write checks against your account with the cash coming from liquidating part of your investment in fund shares. When you take advantage of this privilege, you’ve made a taxable sale that triggers a capital gain or loss that must be reported on your tax return.
Exchange privileges.Some funds allow you to switch your investment from one fund in a mutual fund family to another fund in the same family or a different family. Such exchanges are treated as taxable sales under the federal income tax rules.

Ex-Dividend Factor

Equity mutual funds generally distribute all (or almost all) their annual capital gains to avoid having to pay the corporate income tax on those gains. This can result in large fourth quarter taxable dividend distributions. For many funds, year-end distributions were unusually large for 2021.

If you own shares on the mutual fund’s dividend date of record, you’ll receive the upcoming dividend. The ex-dividend date is usually the dayafterthe date of record. If you purchase shares on or after the ex-dividend date, you won’t receive the upcoming dividend.

The actual dividend payment date is usually a few days after the ex-dividend date. For example, a fund may schedule its 2021 fourth-quarter dividend to be paid to owners of record as of November 29, 2021. So, the dividend date of record is November 29. The ex-dividend date will probably be November 30. The actual dividend payment date might be December 3.

Considerations for Buyers

If you buy into a mutual fund shortly before the ex-dividend date, you’ll get the upcoming dividend distribution — and the tax bill that comes with it. So, you’ll wind up paying taxes on gains the fund earned before you were even a shareholder.

Considerations for Sellers

If you’re considering selling some appreciated mutual fund shares that you’ve owned for more than a year, the resulting profit will be a long-term capital gain. As such, the maximum federal income rate is currently 20%. You may also owe the 3.8% NIIT and, depending on where you live, state income tax.

If you sellbeforethe fund’s ex-dividend date, you won’t receive the upcoming dividend distribution, and your entire profit will be a lower-taxed long-term capital gain, as long as you’ve held the shares for more than a year.

On the other hand, if you sellon or afterthe ex-dividend date, you’ll receive the upcoming dividend distribution. Part of that distribution may consist of high-taxed short-term capital gains. If so, the tax hit will be that much higher.

For More Information

The tax rules for mutual fund shares held in taxable brokerage firm accounts can be tricky. In years of strong stock market performance, the issue of taxable distributions has even greater significance because funds that benefited from the strong market will make bigger-than-normal distributions that can have a major effect on your tax return. If you have questions or want more information, contact your tax advisor.

As a financial expert with a deep understanding of investment strategies and taxation, I'll provide insights into the concepts discussed in the article "After-Tax vs. Pretax Returns: Which Matters?" published on January 19, 2022.

The article delves into the crucial decision-making process when investing in mutual funds, particularly emphasizing the importance of considering after-tax returns for taxable brokerage firm accounts and pretax returns for tax-advantaged retirement accounts. Here's a breakdown of the key concepts:

After-Tax Returns vs. Pretax Returns:
- Taxable Brokerage Accounts: When investing in mutual funds through taxable brokerage accounts, it's essential to assess after-tax returns. This is because gains, losses, dividends, and interest in these accounts have immediate tax implications.
- Tax-Advantaged Retirement Accounts: For accounts like traditional or Roth IRAs, 401(k)s, SIMPLE, or SEP, pretax returns are the primary focus. Taxes are deferred until withdrawals are made, allowing investors to concentrate solely on the fund's pretax performance.
Mutual Funds as Investment Options:
- Professional Management: Mutual funds are managed by qualified professionals who analyze and select securities, making them an attractive option for individuals seeking a low-maintenance, long-term investment strategy.
- Diversification: Mutual funds facilitate portfolio diversification, helping to mitigate risk and volatility over time.
Downsides of Mutual Funds:
- Management Fees: One drawback is the management fees associated with mutual funds.
- Tax Control: In taxable brokerage accounts, investors have limited control over tax implications, especially when the fund sells investments and triggers taxable events.
Taxable Distributions:
- Internal Revenue Code Requirement: Mutual funds are required by the Internal Revenue Code to distribute almost all income and gains as dividend distributions, leading to taxable events.
- Index Funds and Tax-Managed Funds: Index funds and tax-managed funds tend to minimize taxable distributions due to their buy-and-hold philosophies.
Unexpected Tax Consequences:
- Sales and Distributions: Investors may face unexpected tax consequences due to fund sales triggering taxable events, even if the fund's shares have declined in value.
- Check-Writing and Exchange Privileges: Certain transactions, such as check-writing and fund exchanges, can result in taxable sales with associated capital gains or losses.
Ex-Dividend Factor:
- Equity Mutual Funds: These funds distribute annual capital gains to avoid corporate income tax, leading to significant fourth-quarter taxable dividend distributions.
- Ex-Dividend Date: Investors holding shares on the dividend date of record receive the dividend, while those purchasing shares on or after the ex-dividend date do not.
Considerations for Buyers and Sellers:
- Timing and Tax Implications: Buyers should be aware of potential tax consequences related to upcoming dividend distributions. Sellers should consider the timing of selling appreciated shares to optimize tax efficiency.
Tax Rules Complexity:
- Tricky Tax Rules: The article acknowledges that tax rules for mutual fund shares in taxable brokerage accounts can be complex, particularly in years of strong market performance.

In conclusion, the article provides valuable insights for investors, urging them to consider tax implications when choosing between after-tax and pretax returns based on the type of investment account. It emphasizes the importance of understanding the tax consequences associated with mutual fund transactions and distributions.