Avoid the Mutual Fund Tax Trap
Shareholders can be blindsided by unexpectedly high capital gains
Mutual fund investors are sometimes blindsided at tax time when they discover they must pay capital gains taxes on a fund that they didn't sell. For those who think that not selling your mutual fund shares means you don't owe taxes on capital gains, think again.
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In the last couple of weeks, two people who recently filed their tax returns came to me baffled about owing thousands of dollars in capital gains taxes that they didn't expect. Let's look at one of these situations, and then at what you can do so this doesn't happen to you.
A woman who recently met with me brought along her brokerage statement and tax return. One fund alone generated a capital gain of over $63,000, or nearly 30 percent of the total she had invested in that fund at the end of 2015. This not only generated a large capital gains tax, but she ended up owing significantly more because of the ugly alternative minimum tax.
"This happens to me every year, though this is by far the worse," she told me. And she hadn't sold any of the fund shares. "It just happens," she said.
This particular mutual fund is the Columbia Acorn Select Z. You might think she shouldn't complain with such gains, but the fund actually declined slightly in 2015, falling by 0.44 percent, according to Chicago-based investment research company Morningstar. Yet it gave its shareholders a $7.14 per share capital gain.
Why? Because when a mutual fund sells shares of stocks it owns, it passes those gains through to its shareholders — regardless of whether the shareholders sold shares of the fund. This fund sold about 55 percent of its holdings last year.
A spokesperson for the fund family explained that the turnover was due to two things. First, there was a change in the fund manager, who repositioned its holdings. Second, the fund incurred net redemptions, which is more people selling the fund than buying into it. When mutual fund shareholders cash out, the fund must sell shares of the stocks it holds to raise the needed cash.
Morningstar notes that this fund, once a stellar performer, has underperformed over the past several years and has lost over $900 million of the $1.3 billion in assets it managed as of the end of 2011.
Avoiding this tax trap
This unexpected capital gains tax is actually very common and, if you look at your 2015 tax records, it may have happened to you. The way to avoid the trap, or at least greatly lessen the potential damage, is to steer clear of mutual funds that trade (or "turn over") more than the equivalent of 10 percent of the portfolio annually. The lower the turnover rate, the better.
To check a fund's turnover rate, look up the fund at Morningstar.com. The turnover rate can be seen in the upper right of this Morningstar page.
The lowest-cost index funds that follow a total stock market, or a broad index like the S&P 500, typically have very low turnover and rarely pass through capital gains. Finally, exchange traded funds (ETFs), which are similar to mutual funds, are typically more tax-efficient than mutual funds.
Remember that taxes are costs, too. What you don't pay in costs, you are likely to enjoy in the way of returns. Make sure your investing minimizes what you pay both to Wall Street and to the IRS.
Allan Roth is the founder of Wealth Logic, an hourly based financial planning firm in Colorado Springs, Colo. He has taught investing and finance at universities and written for Money magazine, the Wall Street Journal and others. His contributions aren't meant to convey specific investment advice.