Own Mutual Funds? Beware Tax Hits

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Bill Harris, CEO of Personal Capital, explains the dos and donts of managing mutual funds at tax time. 

As you gather various financial documents to prepare your tax return this year, take a look at your investments. Do you own any equity mutual funds? If so, you may be subject to avoidable tax hits. Not sure if your investments are costing you extra? Read on.

Beware Churning

Actively managed mutual funds tend to make a lot of trades during the year. While investment managers may try to maximize returns through frequent buying and selling, they may also be charging you for each transaction. That really adds up if the fund’s turnover rate is 100 percent or more. And if they’re buying and selling to the point of generating strong returns, they may also be creating taxable gains that you’ll have to pay for come April 17 (that’s when tax returns are due this year).

According to Morningstar, the 10 most popular mutual funds by assets under management carried a 1.05 percent average annual tax cost over a five-year period.

Say you invested $100,000 over the past five years. Using a simple average of these funds’ five-year annualized returns, your investment would have grown to $115,467 before tax. After taxes, however, your investment would be worth $106,203. That’s a difference of $9,263.

Low Turnover

Turnover is a very real threat. Let’s look at the top ten mutual funds by assets under management as reported by Morningstar. The average turnover rate is 74.4 percent. This means these particular mutual funds turn over approximately 74.4 percent of their holdings during the year.

To avoid excess transaction fees and lessen the burden of taxable distributions, some investors choose to buy index funds. Index funds track stock indices, such as the S&P 500, and therefore follow a more passive investment strategy. These can be good options, but they aren’t immune to distributions, especially when the target index replaces one stock with another. To mimic the target index, the index fund will also sell that stock, which could result in capital gains. Exchange traded funds (ETFs) pose a similar risk, but they generally carry lower fee structures, making them more attractive overall.

 

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Bill Harris

Bill Harris

Bill Harris is the founder and chairman of Personal Capital. He has spent 25 years building financial technology, notably serving as CEO of Intuit and PayPal. He is the founder of several financial technology companies and has served on the boards of numerous technology firms, such as SuccessFactors, RSA Security, Macromedia, and Answers.com.

One Response

  1. Donavon W. Lopez

    In 2004 I had a settlement from a auto accident.My lawyer called me down to his office,it was payday finally,well when I got there. I was told that I could only get 20,000, of my 90000.I would have to wait ten years for the rest 10,000 of it would be invested and if I dont lose the principle. I would get that and any interest that accrued in the ten years .I was not happy about that but what could I do but disappear for ten yrs.Well in that ten yrs I broke my arm at work a buffalo at the western buffalo company broke my arm which is work comp.No work comp and started work for MIS.So thats where I find out about this mutual fund which I thought MIS started but No they just started it when I started working there after a year it was benefit time from employer and this was it a 25cent raise and accident insurance.So I didnt pay any mind to the fund.I just thought it was more for them.I had no financial advisor confirm or deny any trades because I had no knowledge of being a shareholder or the responsibility of a shareholder.Since this happened 7yrs ago is my money gone.Im the NH and the FBO of the accounts.

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