One of the disadvantages of investing via mutual funds is that the tax consequences are not in my (the investor) control. What does this actually mean? I will answer this in three sub sections

• Tax Terminologies w.r.t. Mutual Funds
• Special Dates w.r.t. Mutual Fund Distributions
• Tax consequences of Mutual Funds

Tax Terminologies w.r.t Mutual Funds

Mutual Fund Distribution:

1. Mutual funds give back money to investors in two ways: through dividends and/or capital gains
2. These money give backs are called Distributions.

Long term vs Short term Capital gains distribution

1. When a share in the mutual fund is held for less than one year and sold, the gains it generates are called Short term capital gains
2. When a share in the mutual fund is held for more than a year and sold, the gains it generates are called Long term capital gains
3. Short term cap gains are taxed as ordinary income….say 33% for many people in the Silicon Valley
4. Long term cap gains are taxed at a rate less than ordinary income….say 15%.
5. So, getting long term cap gains from mutual funds is very tax efficient.

Dividend Distributions

1. When a share OR a bond is held in a mutual fund, it can generate dividends and/or interest.
2. These dividends are taxed at a rate less than ordinary income…..say 15%
3. So, getting dividend distributions from mutual funds is very tax efficient.

Tax Exempt Mutual Funds

1. These funds are generally exempt from federal taxes, and in some cases, exempt from state taxed also depending on residence requirements.
2. Example: Municipal bond fund VCAIX (California MUNIs)  is both federal and state tax free because I am a resident of California.
3. I.e. distributions from tax-exempt funds like VCAIX do not pay tax!!
4. NOTE: There is a limit on how much tax-free income a person can get in one taxable year. AMT (Alternative Minimum Tax) enforces a minimum amount of tax per year i.e. makes sure that there are not too many tax deductions claimed in one taxable year.

AMT Free Mutual Funds

1. From Vanguard. AMT is defined as: A separate tax system designed to ensure that wealthy individuals and organizations pay at least a minimum amount of federal income taxes. Certain securities used to fund private, for-profit activities are subject to the AMT.
2. Each mutual fund can generate gains that are AMT free OR not. If a fund has no AMT exposure, it can’t trigger the AMT, no matter how much you own.
3. Consider the following two Vanguard mutual funds
   1. Mutual Fund with Alternative Minimum Tax = 0%
   2. Mutual Fund with Alternative Minimum Tax = 16.9%
4. If you are a California resident, the first fund is both federal and state tax free. Whether you get $1000 tax free gain OR $1000000 tax free gain, these gains will not trigger the AMT. The second is obviously not…there is a percentage of the gain that will count against the AMT limit. For example, if the AMT trigger limit is 169, getting a $1000 gain will mean $169 of it will apply towards the AMT limit and trigger it.

Form 1099-DIV

1. This form indicates mutual fund earnings shareholders must report on their income tax returns.

Special Dates w.r.t. Mutual Fund Distributions

There are four important dates associated with a mutual fund distribution. This is because a mutual fund goes through a two step process in making distributions.

1. Declaration Date
   1. On this date, the board of directors (for individual stocks) OR the mutual fund company/manager announce to the whole world that the individual stock OR the mutual fund will pay a dividend.
   2. This date has no bearing on your taxes.
2. Ex-dividend Date
   1. First, the fund “declares” the amount of distribution it intends to make and sets aside the necessary amount of cash to match the intended distribution.
   2. Setting aside cash has the effect of lowering the NAV (net asset value) of the fund by the amount of cash that has been “taken out” of the fund for distribution purposes. Note that no cash payment is made to the fund owners at this step….cash is only set aside.
   3. This date that has the most bearing on your taxes.
      1. If you buy a dividend paying stock (or mutual fund share) one day before the ex-dividend date, you will still get the dividend. If you buy on the ex-dividend date, you won’t get the dividend.See Record date section next for more details.
      2. If you want to sell a stock (or mutual fund share) and still receive a dividend that has been declared, you need to sell on (or after) the ex-dividend day.
   4. The ex-date is the second business day before the record date.
3. Record Date
   1. This is the date on which the company looks at its records to see who the shareholders of the company are.
   2. An investor must be listed as a record holder (of the stock or fund shares) to ensure the right of a dividend payout.
   3. The ex-dividend date is usually 2 days before the Record date. And it takes 3 days to record an investor as a record holder. So, to be on the “books” on record date, the stock and/or fund purchase has to happen a day before the ex-dividend date. Purchasing on the ex-dividend date will not lead to the purchaser being on the record books and hence will not be a dividend target.
4. Payment Date
   1. On this date, the fund actually pays the mutual fund share owners real money from the cash pool that is set aside on the ex-dividend date.
   2. This date has no bearing on your taxes

Tax Consequences of Mutual Funds

One of the main disadvantages of investing via mutual funds is that the tax consequences are not in my (the investor) control. What does this mean? Lets see…

1. From the previous section, we saw that Mutual funds can distribute two types of taxable gain to shareholders: ordinary dividends and capital gains distributions.
2. Let us say that I purchase shares of a mutual fund at $10 per share and the share prices rises to $100. Now, if I sell the 10 shares, there can be a taxable gain for the mutual fund because of the increased share price. This taxable gain will be distributed to all the mutual fund shareholders..in proportion to the number of shares that they own. Lets say that this year, I do not have money to pay taxes for the gain. So, I decide to not sell my shares this year.
3. But, if the mutual fund manager sells shares of one of the components of the mutual fund to re-balance it and there is a profit on the shares, then the mutual fund will distribute the gain to all the share holders.
4. This will lead to a gain for me for this year when I do not have the money to pay taxes for it. In the worst case, I may be forced to sell some shares to pay the tax to the government. This is what I meant by saying that the tax consequences are not in my (investor) control.

The other main disadvantage is the timing of the taxes paid. What does this mean?

Assumptions:

• New calendar start date: Jan 1
• Ex-date is Dec15th
• Record date is Dec 17th
• Payment date is Dec 20th.
• Tax year ends on Dec 31st

Scenario 1:

• Assume that Investor A bought 100 shares of a fund for $10 a share on Jan 1st. The shares rose in value to $20 on May 1st. Investor A then sells her shares on May 1st, and owes taxes on $1,000—the capital gain of $10 a share ($20-$10) times 100 shares.NOTE that this tax will be due when taxes are filed in the next calendar year (April 15th of next year is the tax deadline).
• Investor B buys 100 shares at the fund’s new NAV of $20 a share on May 1st, which includes the embedded gains ($20-$10). The shares rise to $30 a share on Dec 1st, and Investor B sells his shares. Investor B would owe taxes on $1,000—the capital gain of $10 a share ($30-$20), times 100 shares.NOTE that this tax will be due when taxes are filed in the next calendar year (April 15th of next year is the tax deadline).
• In other words, Investor A owes taxes on the $10 gain accrued while she owned the fund (Jan 1st to May 1st), and Investor B owes taxes on the $10 gain accrued while he is invested (May 1st to Dec 1st). Each shareholder is paying for his or her own gains earned.

Scenario 2:

• Assume that Investor A bought 100 shares of a fund for $10 a share like in Scenario 1 i.e. Jan 1st. The shares rose in value to $20 on May 1st. Investor A then sells her shares on May 1st, and owes taxes on $1,000—the capital gain of $10 a share ($20-$10) times 100 shares. This is the same as in Scenario 1.
• Now assume Investor B bought his shares on Dec 14th i.e. one day before the ex-dividend date. So, on record date, Investor B will qualify as a record holder. So, Investor B buys his shares at $20 on Dec 14th.
• On ex-date, cash is set aside proportional to the distribution needed. So, the NAV falls to $10 per share, with $1000 (($20-$10) * 100) set aside as cash for distribution. On record date, it is decided that both Investor A and B are record holders and would get the dividend distribution.
• Investor A still owes taxes on $1,000—the $10 gain on her shares, bought at $10 and sold at $20, times 100 shares.
• Investor B bought the stock at $20 and did not realize any gain…but must now pay taxes on $1,000—the $10 per-share distribution ($20-$10), times 100 shares. I.e. it seems like Investor B is paying taxes on zero gain…is this possible? No. Read next.
• The distribution reduces the fund’s NAV to $10. If Investor B pays the taxes from other assets and reinvests the full amount of the $1,000 distribution, he will now own 200 shares. The first 100 shares were purchased at $20 a share, while the second 100 were purchased at $10 a share. Investor B’s average cost basis for tax purposes is $15 a share.
• Post the distribution (say May 1st of next year), lets say that the shares then rise by 50 percent, as in Scenario 1, to a new value of $15 a share.
• When investor B sells his 200 shares at $15 a share on May 1st of next year, for tax purposes he is treated as having purchased all those shares at his average cost basis of $15 per share. Thus, he has no new tax liability because he has already paid taxes on his own gain.

Is Investor B paying taxes on zero gain?

• Investor A paid her own taxes on the $1,000 gain when she sold shares at $20 with a cost basis of $10; she delayed paying taxes until she sold.
• Investor B paid taxes on the $1,000 distribution up front, but owed no additional taxes when he sold his shares with the same price ($15) as his cost basis. Thus, he pays taxes only on the $1,000 that he earned while he owned the shares.
• For Investor B to pay taxes upfront, he has to have some additional money set aside OR have other assets. If he has no money set aside, then other assets may have to be sold to pay taxes. This forced sale may lead to a loss (selling low, bought high) OR may lead to more taxation due to capital gains. This is the other main disadvantage of mutual funds.

Compared to other forms of investments, the only issue with a mutual fund is the timing of the taxes paid, not the amount of taxes paid.

• Taxes may be paid sooner (if gains accrued before purchase are realized and distributed) or
• Taxes may be paid later (if losses accrued before purchase offset realized gains)
• But total taxes paid will be the same.

Reference:

I read many web links to understand this, but I will list one main link that was helpful to me with actual examples.

• http://www.ici.org/policy/current_issues/faqs_taxation_investors