Why I hate Mutual Funds Part 2: TAX INEFFICIENCY

Mutual funds held outside of retirement accounts are not tax-efficient. “Depending on the timing of their investment,” notes the U.S. Securities and Exchange Commission, “investors may also have to pay taxes on any capital gains distribution they receive—even if the fund went on to perform poorly.”

It is different with stocks and bonds. The investor pays income tax on dividends and interest received, but pays capital gains taxes only when a security is sold at a profit. With mutual funds, however, the investor has no control over the taxable distributions created by fund managers, yet the law requires that funds distribute all gains from the sale of securities to their shareholders immediately.

The result? Taxes cost investors 1% to 1.2% of their stock mutual funds each year, according to Morningstar.15

How mutual funds raise tax liabilities

A mutual fund held outside of a tax-deferred account can generate taxes without an investor even realizing it.

Take a hypothetical mutual fund. Let’s say some stocks in the fund have appreciated. The appreciation occurs before you buy fund shares. Soon after you buy the fund, the manager decides to sell some of the appreciated stocks. You personally never realize+ any gains (though you paid a higher share price to buy the fund), but you certainly inherited the tax liability associated with those gains.

By buying a mutual fund, you might unwittingly owe taxes on gains that others receive. I despise that.

Deferred gains might be taxed at future higher rates

A traditional IRA allows you to defer taxes. It allows you to earn interest, dividends and gains from securities growth without generating associated taxable events until your retirement. That’s good.

The combination of a tax-deferred IRA and a mutual fund, however, can create problems. You don’t pay taxes today, but you will pay them in the future —when your tax rate might very well be higher.

Individuals need to know their tax situations and get good tax advice. A couple with less than $75,300 of taxable income (2016), for example, could incur taxes on dividends and capital gains that would normally have a 0% tax rate. By owning shares of mutual funds that buy dividend-generating stocks within traditional IRAs, they could unintentionally transform their 0% dividend tax rate into an ordinary income tax rate (10%, 15%, 35%, etc.) at whatever rate ordinary income is taxed in the future when they take the distribution.

Thus, the IRA-mutual-fund combo can convert a zero-tax event into a taxable one. Nothing to like about that.