Tax season approaches. Mutual Fund investors are making unpleasant realizations. Most lost money in 2018, yet they must pay taxes.
Why did this happen?
Mutual funds are companies. When you invest in a mutual fund, you are buying shares in a company whose sole way of making money is investing in other securities.
All companies pay taxes when they make money. Mutual funds are no different. When they sell a stock for a profit, those gains are taxable. Mutual funds distribute those gains to their shareholders. They make a payment to you and report it to the IRS. Your 1099 represents the capital gains they realized during the year, offset by their losses. As soon as the fund does that, the taxes are no longer their liability. They’re yours.
This gets frustrating in years like 2018. Most asset classes and funds were down. However, if fund managers sold stocks for a gain, you got a tax bill. For example: Columbia Acorn International (ACINX), was down -16% in 2018, but still distributed almost 20% of its assets as capital gains. In other words, if you owned $10,000 of Acorn International in a taxable account on Jan 1, 2018, one year later you would have $8,400 and a $600 tax bill. Nuts!
How can I avoid this?
ETFs. ETFs’ structure is more tax-efficient than mutual funds’. The reasons why are complicated and are better left for another post. Last year, over 60% of mutual funds distributed capital gains. 6% of ETFs did.
Blackrock runs very popular S&P 500 index funds. One is structured as a mutual fund and one trades as an ETF. Both hold the same portfolio, tracking the same index. The only differences are the expense ratio and the mutual fund/ETF structure.
The mutual fund distributed capital gains each of the last 5 years. Because of its structure, the ETF did not. Using Morningstar’s Tax Cost Ratio, we estimate the tax bill from capital gains distributions paid out by the mutual fund at 19 basis points/year.
Don’t worry about switching ETFs providers to save 2 basis points on an index fund. You get bigger bang for your buck saving 0.19%/year by using the ETF structure where possible in taxable accounts. Index ETFs can do what index mutual funds can do. They just do it more tax-efficiently.