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Mutual Funds Snare The Public In A Hidden Tax Trap!
By: Dr. Scott Brown, Ph.D.
One among many ways you lose money in non-indexed mutual funds is the tax trap.
You may have to pay taxes even when your mutual fund loses money! To many people
this is painfully unexpected. Here is how this counter intuitive event occurs.
By law, mutual funds do not pay taxes. Instead, they pass on those taxes to you,
the shareholder in the mutual fund. If the fund manager sells a stock for more
than it cost the fund a profit is generated. This profit is called a capital
gain and it is taxable. Capital gains are taxed at your ordinary income tax rate
which is between 28% and 38.6% for most investors if the fund held the stock for
less than a year. If the stock was held for more than a year, in other words
long term, the tax is 20%.
There are a couple of reasons why mutual funds pay taxes. If the fund does
poorly investors will bail out. The mutual fund has to sell off stock to pay the
investors who leave. Even if you are not one of the investors jumping ship you
will still have to pay your portion of the capital gains tax.
Dividends are another reason that taxes come due. Dividends are taxed at the
per-share earnings distributions that companies make out of their quarterly
earnings. Many investors instruct their mutual fund to automatically reinvest
their dividends. This means that the fund uses the money to buy more shares in
your name. Even if you reinvest and never get a penny of the dividends, they are
subject to tax, according to the IRS.
Another reason you may get a tax bill is due to high turnover. Turnover measures
the frequency with which a fund manger buys and sells shares, sometimes in
search of the next high-flying stock or undervalued stock on the verge of taking
off. According to Lipper, the average fund in 2000 showed a turnover rate of
122%. This means that the entire portfolio changed between January and December,
and 22% of the replacement shares changed as well.
This is the ultimate case of account churning! You simply have to understand
that when you buy into a fund you are buying into a tax liability. The best way
to avoid these taxes altogether is to restrict your purchases of mutual funds to
your 401(k) and try to only buy indexed mutual funds such as the Vanguard 500 (FINX).
About the Author:
Dr. Scott Brown, Ph.D., the Wallet Doctor, is a successful investor. Dr. Brown
holds a Ph.D. in finance. The Wallet Doctor is sought after for investment
advice and coaching. For more information visit Dr. Brown’s site at http://www.BonanzaBase.com
or sign up for his investment tips at http://www.WalletDoctor.com
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