The Extra Tax Bill Mutual Fund Investors Will Pay This April

As if taxes weren't already painful enough, most investors will pay even more on their 2014 tax return. The money siphoning culprit to be aware of this April will appear on IRS Form 1099-DIV. This is the form detailing an investor's taxable dividend income from mutual funds and stocks. Brokerages mail these out each February, so be ready for higher than expected taxable income.

You Got My Attention, Why Is This Happening?

When mutual fund managers sell holdings within a fund for a profit, the IRS gets to collect their cut. This tax owed is a capital gain. Normally fund managers offset as many gains as possible with losses, the same as an investor would. Losses are extremely hard to find these days. Remember that bull market we've all enjoyed for the last 6 years? Not so many losses these days... Because conventional mutual fund managers tend to trade frequently, they've racked up a lot of taxable profits last year. These profits are passed on to the investor in the form of a capital gain distribution, technically called a dividend. Dividends are normally paid out in December after all the year's trades are executed.

Putting Some Numbers Into The Formula

According to Morningstar, mutual funds will pay out 16% on average in year end distributions. Let's assume an investor holds $100,000 in a mutual fund that pays out 16% in a year end dividend. That $16,000 of extra dividend income is normally taxed at long term capital gains rates (15% - 20% for most investors). That equates to an extra $2,400 to $3,200 tacked on top of all the other taxes the investor is required to pay.

Situations When A Year End Distribution Won't Seem Fair

The first situation occurs when an investor doesn't sell any portion of their mutual fund in a given year, but still has to pay capital gains tax. Even though the investor adhered to a buy and hold long term philosophy, they are punished because their fund manager didn't. The second scenario is when the investor buys the fund near the end of the year, then immediately gets whalloped with a taxable fund distribution. Last, realize that investment taxes represent a direct drag on returns (not in 401(k) or IRA accounts of course). It's easy to exclude the tax cost of investing because it never appears on an investment statement.

How An Investor Can Avoid These Tax Surprises

The first thing to be done is to recognize conventional mutual funds aren't the only diversified investment option. Index funds and exchange traded funds (ETFs) present a tax efficient alternative. These investments track an index like the Dow or S&P 500. Because indices are designed to represent the market, their holdings change very little, if at all, throughout the year. This greatly reduces, and in some cases eliminates, the amount of year end taxable distributions to the investor.

To check up on how tax efficient an investment actually is, use Morningstar's free fund screener. I often pick on a mutual fund my wife and I owned for years, American Funds Growth Fund of America. The numbers below were taken from Morningstar on 2/26/2015. After I entered the name of the mutual fund in Morningstar's free search field, I navigated to the Tax tab to generate the following info:

The first clue Morningstar provides is the Tax-Adjusted Return. See the tax drag on performance I was talking about? Other clues regarding tax (in)efficiency can be found in the Tax Cost Ratio numbers and the Potential Cap Gains Exposure data. If you want a valid comparison, test your mutual fund against a similar index fund or ETF using Morningstar's free screener. You'll be surprised at the results!

Summary

If you're an investor using conventional mutual funds in your portfolio, you'll probably experience more tax pain in 2014 than you have in any other year over the last decade (if your portfolio value had stayed the same). It's ok to question whether you should continue to use mutual funds to achieve your investment goals. If you own investments in a taxable account and you're not familiar with index funds or ETFs, you should be! They are diversified, tax efficient, and they deliver the market's returns (something mutual funds rarely accomplish).

Thanks for reading and have a fantastic day!

#taxes #evidencebasedinvesting