The non-indexed mutual funds make you lose money by making you pay taxes. You might be liable to pay taxes though your mutual fund makes a loss. However for many people this is highly unforeseen event. This is how this contradictory event takes place. Legally, mutual funds do not have to pay taxes. Instead they pass on these taxes to the shareholders of the mutual fund, which means you are forced to pay the taxes.
If the fund manager sells the stock at a price higher than its cost, the fund makes the profit. This profit is known as a capital gain and is taxed. Capital gains carry the regular income tax rate of 28%-38.6% for the investors holding the stock below the year. For the investors holding the stock for over a year or long term, the tax rate is 20%.
There are some reasons why mutual funds have to pay taxes. If the fund performance is poor, investors tend to leave. The mutual fund is forced to sell stock to pay the leaving investors. Though you may not be one of the investors wanting to leave, you will still be taxed your share of the capital gains tax.
The other reason for paying taxes is the dividends paid. Dividends are taxed as per share income distributions that companies make from their quarterly earnings. Many investors choose to automatically reinvest their dividends. This provides the fund with the money to purchase more shares for you. So if you reinvest and yet do not take out a single cent from the dividends, they are still taxed as per the IRS rules.
The other reason for paying tax is the high turnover. Turnover is the rate at which a fund manager purchases and sells shares, at times to avail of the next winning stock or undervalued stock that is about to shoot up. The average funds in 2000 had a turnover rate of 122%. It implied that the whole portfolio between January and December had changed and about 22% of the replacement shares too changed.
It is the extreme case of account churning. You should remember that when you are purchasing a fund you are taking on the tax liability. The excellent method of not paying these taxes is to limit your purchases of mutual funds to your 401(k) and just buy indexed mutual funds.
Tags: Mutual Funds, TAX TRAP