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Can You Lose When You Gain?

The pros and cons of mutual funds and how their gains differ from other investments.

By
Laura Adams, MBA,
Episode #099

 

This episode is about the advantages and disadvantages of investing in mutual funds.

Taxes on Top of Losses

As we all know, many people have lost investment money due to the stock market volatility in recent weeks. It’s been a tough time for the vast majority of investors. But what’s really tough is losing money in your mutual fund, and then having to pay taxes on that losing investment! Let me explain…

Even though many mutual funds have suffered big losses, some still have capital gains. A capital gain is simply the difference between the amount you pay for a capital asset when you buy it, and the amount you receive for that investment when you sell it. If you make a profit from the sale, you have a capital gain that’s taxable. It you lose money from the sale, you have a capital loss. Capital gains are allowed to be offset by capital losses.

Phantom Gains are Scary

A situation where you owe tax even if you experience a negative return on investment is called a phantom gain. No, that’s not a left-over joke from Halloween! Phantom gains are common in a down market, like we’ve experienced lately. They can occur when investors decide to get out of a declining fund. If the investor wants to sell, the mutual fund may have to raise money to pay the shareholder. The fund would do this by selling investments, even profitable ones.

Mutual Fund Overview

If you’re not familiar with mutual funds, they’re companies that invest in stocks, bonds, money markets, assets, and other securities, or a combination of these. The investments that a mutual fund owns are called its portfolio. It’s a convenient package of many individual investments that would be complicated for a typical investor to manage on their own. Mutual funds allow people without financial experience to easily invest small or large amounts of money.

Capital Gains Treatment

But there’s a big difference in how capital gains are handled with mutual funds versus with individual securities. When you buy and hold a stock, for example, you pay tax each year on what you earn. The income could come from interest earned or from dividends received. But you don’t pay capital gains tax until you actually sell the stock and bank a profit. With mutual funds, this same information is true. But in addition to paying personal capital gains tax on shares you sell and profit from, you also have to pay taxes each year on the fund’s capital gains.

This is because U.S. tax law requires mutual funds to distribute capital gains to their shareholders. And these distributions are taxed at the long-term capital gain rate, no matter how long you’ve owned the shares. So if a mutual fund manager sells some of the underlying securities for a profit, which can’t be completely offset by a loss, they must pass the taxable gain along to shareholders. This happens even if the fund had poor performance after you bought it

Pros and Cons of Mutual Funds

Does this mean mutual funds are bad investments? Absolutely not. Mutual funds offer shareholders great benefits such as professional management, diversification, liquidity, affordability, and convenience. But every investment vehicle has its pros and cons. I want to make you aware of a couple more disadvantages to mutual funds to simply keep in mind:

Most charge fees. Mutual funds can be expensive to operate. That’s why investors get hit with annual fees and sales commissions regardless of a fund’s performance. However, there are some no-load funds that can minimize management fees. If you feel comfortable investing without the services of a broker, consider buying mutual funds directly from a no-load fund family to save on expenses.

Share prices are calculated just once a day. This is in contrast to an individual stock for which you can monitor price changes minute by minute, if you like, by checking websites such as etrade.com or scottrade.com. But because a mutual fund is made up of multiple securities, its price depends on the fund’s net asset value or NAV which is calculated at the end of the trading day. But if you rarely reallocate money, or buy and sell funds, within a fund family, this may not be a problem for you.

Mutual Funds and Tax-Deferred Accounts

One way to eliminate taxes on mutual fund distributions is to buy them within a retirement account. This is because retirement accounts such as IRAs and 401(k)s are examples of tax-deferred accounts. That means your profits are not reported as capital gains. You don’t get hit with any taxes until you take your money out. At that time your profits are taxed as ordinary income, not capital gains.

Mutual Funds and Taxable Accounts

But if you own mutual funds outside of a qualified retirement account, be prepared for any possible tax liability this year. Many mutual funds ended their fiscal year at the end of October, so be on the look-out for their distribution estimates so you can plan accordingly.

Here’s a tip if you’re investing in mutual funds in a taxable account: consider waiting to buy more shares until after the fund has made any capital gains distributions for the 2008 tax year. I’ll put a link in the show notes to IRS Publication 564 which contains in-depth information about the taxes associated with investing in mutual funds.

For more information please check out this episode of The Winning Investor's show, which compares mutual funds with Exchange Traded Funds (ETFs).  And in a future episode, I'll cover some strategies for investing success.

Administrative

I’m glad you’re listening. Find a transcript of this show as well as all contact information at moneygirl.quickanddirtytips.com.

Chi-Ching, that's all for now, courtesy of Money Girl, your guide to a richer life.

Additional Resource:

Introduction to Mutual Funds from the SEC

Image courtesy of Shutterstock

 

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