Mutual funds have served a laudable role in making investing accessible to millions of Americans and they continue to dominate the retail investment landscape. But be on the lookout for tax surprises as we draw closer to year end if you hold mutual funds in a taxable account. Fund investors in tax deferred accounts like IRAs and 401(k)s can stop here and skip ahead to Beetle Bailey.
Investment funds represent large pools of investor capital being managed to a specific objective. Throughout the year, the fund manager buys and sells securities to adjust to changing fundamentals in the underlying stocks. The fund must also respond to new cash inflows with more purchases, and to requests for redemptions by selling some of its current portfolio. Each sale transaction results in either a capital gain or loss which must eventually be passed along to the fund shareholders.
This process typically occurs during November and December. Gains and losses from portfolio transactions are netted against each other and the net gain (or loss) is paid out to shareholders, creating a tax event.
Here’s how it works. Suppose you own 500 shares of stock mutual fund XYZ, currently valued at $10 per share for a total value of $5,000. As the result of various sales from the portfolio, the fund company reports to you a 10% capital gain distribution of $500. This $500 gain is paid out to you (credited to your fund account), and the market value of the fund (called the net asset value or NAV) is reduced by $500, leaving an NAV of $4,500.
In most cases, the distribution is automatically reinvested in more shares of the fund, bring your NAV back to $5,000. However, you will now receive a sweet little note on your form 1099 reminding you of your obligation to pay taxes on the $500 distribution. And although this happens every year, investors often forget or simply misunderstand the implications since their net position remained unchanged.