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How To Avoid The Hidden Tax Hits Of Owning Mutual Funds

Bill Harris, CEO of Personal Capital, explains the dos and don’ts of managing mutual funds at tax time. Re-posted from Forbes online.

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.

Read the full article on Forbes.

More on tax planning on Daily Capital.


The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.

Any reference to the advisory services refers to Personal Capital Advisors Corporation, a subsidiary of Personal Capital. Personal Capital Advisors Corporation is an investment adviser registered with the Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training nor does it imply endorsement by the SEC.

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