Mutual funds are an attractive investment option, especially for people who are looking for a low-maintenance, long-term way to participate in the securities markets. These funds are managed by professionals who should be well-qualified to judge which securities are attractive bets. Mutual funds also make it easier to maintain a diversified portfolio, which can reduce risk and volatility over time.
But there are two major downsides. The first is the management fees the funds charge. The second is that, if you hold fund shares in a taxable brokerage account (not a tax-advantaged retirement account), you have limited control over taxes.
You control when you sell your shares in the fund and, thus, you can consider the tax consequences before making a decision to sell those shares. But there also can be tax consequences for you when the fund sells investments it's holding. And the fund—not you—decides which of its investments will be sold and when. If sales the fund makes during the year result in an overall gain, you'll receive a taxable dividend distribution, whether it's wanted or not.
In fact, you can wind up owing taxes even if your fund shares have declined in value. That happens when the fund sells securities that appreciated while it was holding them, but the price of the fund's shares went down after you bought in. In the not-too-distant past, this scenario has occurred and created some negative tax results for fund investors.
In 2021, the markets were generally bullish, so many mutual fund investors could face unexpected tax consequences for the year. Here's the full story on federal income tax angles for mutual fund investments held in taxable accounts.
Taxable Distributions
Mutual funds make taxable distributions because the Internal Revenue Code requires them to pass out as dividend distributions almost all of their income and gains earned during the year. Otherwise, the funds get hit with the corporate income tax.
The problem of unwanted taxable distributions is less of an issue for the following two types of funds:
In contrast, funds that actively churn their stock portfolios can generate significant annual distributions in a rising market. The tax implications of these payouts can be annoying enough, but it's even worse when a large percentage comes from short-term gains. Distributions that arise from short-term gains are taxed at your regular federal rate, which currently can be as high as 37%. In addition, you may owe the 3.8% net investment income tax (NIIT) and, depending on where you live, state income tax.
On the other hand, funds that generally buy and hold their investments for longer than a year will pass out distributions that are mainly long-term gains taxed at a federal rate of no more than 20% under the current rules. However, the 3.8% NIIT and state income tax can still increase the tax bite.
Important: It's possible that Congress will increase some federal tax rates for individuals. If so, 2021 rates will probably be unaffected, but 2022 rates could go up for some taxpayers. We'll keep you up to date on any changes.
After-Tax vs. Pretax Returns: Which Matters?
When investing in mutual funds using a taxable brokerage firm account, you should look at what kind of after-tax returns various funds have been earning. Use those figures as one factor when choosing between competing funds.
However, if you're using a tax-advantaged retirement account—such as a traditional or Roth IRA, 401(k), SIMPLE or SEP—to hold mutual fund investments, you can focus strictly on each fund's pretax returns and ignore all the tax issues explained in the main article. With these accounts, you only owe taxes when you take withdrawals. Until then, gains, losses, dividends and interest that accumulate in your account have no tax impact and, with a Roth IRA, the gains, dividends and interest can be permanently federal-income-tax-free if you only take tax-free qualifying distributions.
Unexpected Tax Consequences
As with regular stock shares, you can make outright sales of mutual fund shares. When you sell shares outright, you know that you've triggered a capital gain or loss for tax purposes and whether it's a short- or long-term one.
However, mutual fund companies allow investors to make other transactions that are also treated as taxable sales. These transactions provide added convenience, as long as you understand the tax ramifications. The following two common transactions can result in unanticipated mutual fund share sales:
Ex-Dividend Factor
Equity mutual funds generally distribute all (or almost all) their annual capital gains to avoid having to pay the corporate income tax on those gains. This can result in large fourth-quarter taxable dividend distributions. For many funds, year-end distributions were unusually large for 2021.
If you own shares on the mutual fund's dividend date of record, you'll receive the upcoming dividend. The ex-dividend date is usually the day after the date of record. If you purchase shares on or after the ex-dividend date, you won't receive the upcoming dividend.
The actual dividend payment date is usually a few days after the ex-dividend date. For example, a fund may schedule its 2021 fourth-quarter dividend to be paid to owners of record as of November 29, 2021. So, the dividend date of record is November 29. The ex-dividend date will probably be November 30. The actual dividend payment date might be December 3.
Considerations for Buyers
If you buy into a mutual fund shortly before the ex-dividend date, you'll get the upcoming dividend distribution—and the tax bill that comes with it. So, you'll wind up paying taxes on gains the fund earned before you were even a shareholder.
Some of an upcoming distribution may consist of long-term capital gains and qualified dividends from stocks held by the fund. The current federal income tax rate on that portion of the distribution can be up to 20%, plus another 3.8% for the NIIT if you're subject to it.
Conversely, some of an upcoming distribution may consist of short-term capital gains and interest. The current federal income tax rate on that portion can be up to 37%, plus another 3.8% for the NIIT if you're subject to it. You may also owe state income tax, depending on where you live.
For example, the ZIPPY Fund declared a $5-per-share fourth-quarter dividend to owners of record as of November 29, 2021. The dividend date of record was November 29. The ex-dividend date was November 30. The dividend was paid on December 3.
On November 24, you decided to invest $40,000 from your taxable brokerage firm account to buy 1,000 shares of ZIPPY at $40 per share. Because you bought the shares before the November 30 ex-dividend date, you received the dividend of $5 per share (for a total of $5,000). Other things being equal, the per-share price of ZIPPY dropped by $5 on November 30 (the ex-dividend date) to reflect 1) the fact that incoming shareholders didn't get the upcoming dividend, and 2) the reduction in the fund's net asset value (NAV) due to paying out the dividend.
So, assuming no other influences on ZIPPY's price, the shares were selling for $35 on November 30. However, you paid $40 for your shares, plus you're on the hook for taxes on the $5,000 dividend. If you had waited to buy your shares until on or after the ex-dividend date, you could have sidestepped the dividend, and the related tax hit, and bought more shares with the same $40,000 investment.
To avoid this tax problem, you could have contacted the fund to find out the next ex-dividend date and the expected dividend amount. Then you could have delayed your purchase by just a couple days and gotten a better tax result.
Considerations for Sellers
If you're considering selling some appreciated mutual fund shares that you've owned for more than a year, the resulting profit will be a long-term capital gain. As such, the maximum federal income rate is currently 20%. You may also owe the 3.8% NIIT and, depending on where you live, state income tax.
If you sell before the fund's ex-dividend date, you won't receive the upcoming dividend distribution, and your entire profit will be a lower-taxed long-term capital gain, as long as you've held the shares for more than a year.
On the other hand, if you sell on or after the ex-dividend date, you'll receive the upcoming dividend distribution. Part of that distribution may consist of high-taxed short-term capital gains. If so, the tax hit will be that much higher.
For More Information
The tax rules for mutual fund shares held in taxable brokerage firm accounts can be tricky. In years of strong stock market performance, the issue of taxable distributions has even greater significance because funds that benefited from the strong market will make bigger-than-normal distributions that can have a major effect on your tax return. If you have questions or want more information, contact your SSB tax advisor.