You meet with your accountant and he informs you that you need to pay capital gains taxes this year even though the mutual fund you bought posted negative returns. You have not sold any funds or made any portfolio changes. How does this happen? Why do some people need to pay capital gains taxes if they lost money and did not trade?
When you own a mutual fund in your brokerage account, you may have to pay taxes even though the value of your fund went down and even if you did not sell the fund or realize any gains. This makes it important to know which funds may generate lots of taxes and to optimize your asset location—brokerage, 401(k), IRA, etc.—for each fund you own. (For related reading, see: The Ultimate List of Painful Financial Mistakes.)
Breaking Performance Down
If you check www.morningstar.com, you will see the difference in performance for many funds before and after-tax. For example, in the last 12-months, taxes may have decreased the performance of PIMCO Long-Term U.S. Government bond fund by more than 21% in a regular taxable brokerage account! The fund has suffered some withdrawals/outflows (fund redemption by shareholders) in the last two years, which created this large difference. The outflows required the fund manager to sell securities (stocks, bonds) which triggered the capital gains.
Although the fund performed well in the past twelve months with a return of more than 7%, its after-tax return was a loss of more than 13%. This occurred as many investors in the fund chose to withdraw money from the fund. As a result, the fund manager was forced to sell many securities to cover the redemptions. The process triggered capital gains tax.
Imagine if you invested $100 in the fund one year ago—you would have lost nearly $14 as a result of taxes on assets that were in the fund before you ever invested your own money in the fund.
Taxes can have significant effects on stocks as well. An example would be the well-known Acorn Fund from Chicago, which was one of the best funds between 1970 and 2010. In the last 15 years, the fund has outperformed the S&P 500 or its category (top 13%) by more than 2% per year. Yet in the last 12 months, taxes may have decreased the performance of Acorn by more than 9% in a regular taxable brokerage account even though the fund performance was negative!
If you bought $100 of Acorn one year ago, you may have about $94 today. In addition, you had to pay $9 of capital gains tax (IRS form 1099-DIV).
Mutual funds pass through capital gains that are only recognized when a holding or security is sold, so the fund manager can postpone capital gains. That creates a liability for unrealized gains that a new buyer/shareholder picks up when he buys into the fund. A mutual fund with large outflows will be forced to recognize these gains. Acorn's shareholders experienced this over the past few years. (For related reading, see: 15 Ways to Reach Your Financial Goals.)
Even without selling shares of a fund, investors can incur capital gains taxes triggered by the sale of individual securities by the fund manager. Investors buy mutual funds because they're simple, but we recommend looking into finer details, specifically tax ramifications of any financial security, before making a decision to invest. Some funds have a high turnover and may generate high taxes. Even though stock performance has been weak over the past twelve months, many mutual funds still have highly appreciated securities in their portfolios following the market's seven-plus-year rally (U.S. stocks are up 250% since March 2009); those gains haven't been taxed yet.
If there is a change in a fund manager, it may prompt the sale of those highly appreciated securities by the new fund manager. Those gains must then be distributed to shareholders and are taxable. Note that investors in funds or ETFs in non-U.S. bank/brokerage accounts may also have high U.S. taxes on a fund that went down in value and that was not even sold due to PFIC rules.
Taxes are one of the few guarantees in life. Tax strategies can help minimize the amount you may need to pay. Remember that income and capital gain distributions from holdings inside of an IRA, 401(k), 403(b), 529 plan, or health savings account (HSA) don't have any tax consequences unless you withdraw from them for non-qualified distributions. And even funds that appear to have low turnover strategies and historically low capital gains distribution may have investment process changes that lead to higher capital gains distributions.
There are also differences between short- and long-term capital gains. The former are worse than the latter because they're taxed at your ordinary income tax rate, which may be higher. You can receive information about this topic from your fund manager in November and December. Some investors prefer to sell a fund before it makes large distributions. It is also good to know that if you're reinvesting the distributions from your fund, you can adjust your cost basis upward to account for them (and pay fewer taxes later).
The Bottom Line
When possible, some investors put fixed income, commodities, real estate investment trusts (REITs), high-dividend paying stocks, money market funds (which generate ordinary income or short-term capital gains), and stock funds with high turnover in tax-deferred accounts like 401(k)s, 403(b)s, IRAs, HSAs, VAs, VULs, 529 plans, etc., and put equity funds (low turnover or international) in taxable accounts. You may find that a strategy like this will help reduce your overall tax burden. (For more, see: The Impact of Low Rates on Your Investments.)