A Deeper Dive Into Mutual Fund Tax Issues


Posted in: Economics, General, Stock Market, Thought of the Week

Last week our Investment Committee discussed the performance of mutual funds vs. the stocks of the companies that manage the funds. During the explanation of why the company’s stocks tend to massively outperform the funds they manage, our Investment Committee also hinted to the many tax issues that plague mutual funds.

The first tax problem with mutual funds is the inability to use capital losses to offset gains. Let’s start with an example. You want to purchase 100 shares of Apple at $100/share for $10,000 total. After a few months the stock price falls to $70. After some further research on the price decline, you decide to sell all of the Apple stock in your portfolio. Therefore, you would have a loss of $3,000 from this investment ($7,000 – $10,000 = -$3,000).

The U.S. tax code would allow you to deduct an amount, up to $3,000 annually, from gains in a given year. If the rest of your portfolio had gains of $25,000, you could reduce your tax liability to $22,000 ($25,000 – $3,000 = $22,000). However, mutual fund taxes work quite differently. Let’s say that you bought a mutual fund instead of the stock itself, and that mutual fund bought Apple at $100 and sold at $70 for a loss. Since you own shares of the mutual fund and not the stock, you will not be allowed to deduct the loss. In other words, if your mutual fund has a loss in a specific stock, you do NOT get to deduct the loss on your tax return.

The second problem with mutual funds involves unanticipated tax obligations that happen more frequently than most investors may realize. Let’s try a hypothetical scenario. Suppose a mutual fund company bought IBM stock at $100/share back in 2003. After a few years in a rising equity market, you decide to buy shares of that mutual fund in 2007 when IBM’s stock is around $150/share. At some point the markets begin to fall, and the fund manager of that mutual fund decides that IBM is no longer a good investment and sells the stock at $130/share. The mutual fund has made a profit of $30/share ($130 – $100), however, you never really gained anything because you bought into the mutual fund when IBM’s stock was around $150/share. In fact, you actually lost money on this individual stock within the mutual fund.

Here is the part where mutual funds are very deceiving. You would still have to pay your share of the gains tax on the mutual fund capital gain, even though your mutual fund investment lost money on this trade. Although this is a fictional scenario, this very circumstance happened to millions of mutual fund investors during the financial crisis in 2008. Fund managers received so many redemptions from investors that they had to sell stocks within the fund to raise cash. Subsequently, many investors remaining in the funds were then forced to pay unexpected taxes at the end of an already difficult year. To make it simple, mutual fund investors pay capital gains taxes each year that there are trades within a fund, despite any action from the investor.

In summary, it is pretty clear why our Investment Committee stays away from mutual funds. Tax issues are real and adversely impact a large number of investors every year. Mutual funds had their time, but they are now obsolete in the face of the products that we use to manage our client’s accounts.

Read this week’s Thought of the Week to get a more in-depth look into the tax implications of owning mutual funds.

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As an Investment Advisory Representative working in conjunction with Global Financial Private Capital (GFPC) we are provided weekly thoughts on what is happening in the economy and the market. Written by our investment committee at GFPC we find these thoughts to be informative and interesting.