Why Mutual Funds in Taxable Accounts Can Lead to Costly Tax Bills
Mutual funds offer great benefits for investors, but be aware of unknown taxes. While investing in mutual funds can be a great way to invest in the market and build wealth over time, holding them in taxable accounts can result in unexpected tax bills that can significantly impact your portfolio’s returns. Now, three main factors impact the performance of your investments, which include: Expense Ratio: The annual cost of owning the fund (automatically factored in). Capital Gains Distributions: Taxes due from selling an investment for a gain. Income Distributions: Taxes due from dividends or interest income payments. Many of these factors can easily be understood before purchasing a fund, but one that may contain unknown risks for investors using taxable accounts is capital gains distributions. The Capital Gains Distribution Trap If you didn’t know, mutual funds distribute capital gains to shareholders when the fund sells underlying holdings at a profit (even if you haven’t touched the fund yourself). These distributions are taxable events, creating unexpected tax liabilities for investors using traditional brokerage accounts. Additionally, capital gains distributions may be triggered in any given year, even if the fund’s value has declined. The risk becomes significantly higher when investing in actively managed funds or those with high turnover rates, where the fund frequently buys and sells the underlying assets. Even index (passively managed) mutual funds can still trigger unintentional capital gains to shareholders, but the overall impact is likely to be less. Real-World Example To see how much a mutual fund has previously triggered in capital gains distributions, you’ll need to look at the distribution history. According to Morningstar, the Fidelity Magellan Mutual Fund (FMAGX) has distributed short- and long-term capital gains to investors over the past few years. Looking at the year 2023, FMAGX distributed $0.154 long-term capital gains on Dec. 8th, 2023, and $1.237 on May 12th, 2023, resulting in a total of $1.44 in long-term capital gains distributed in the given year (image below). Based on the average Net Asset Value (NAV) of $11.18, that means 12.80% of the amount of FMAGX that you owned would be triggered as forced income. This means if you had $100,000 invested in the Fidelity Magellan Mutual Fund (FMAGX) in 2023, the fund would have generated $12,880.14 of forced income to you, even if you didn’t touch it yourself. On top of that, looking at the prospectus for FMAGX, it’s reported that over the past 10 years, the fund has averaged a 13.07% annual return. This sounds great until you look at the return after taxes on distributions, which reveals the true average to be 11.09%. That is nearly a 2% annual drag on your portfolio over 10 years. Granted, this takes into account that you are in the highest federal income tax bracket, but regardless, the impact is significant, especially over a long period. Crazy enough, the image above shows a great example of how a $500,000 portfolio with a 2% annual tax drag could end up costing you $665,000 in potential gains. But keep in mind that for index mutual funds, capital gains distributions are less common, but they still carry some risk of impact, just typically on a much smaller scale. In fact, the Fidelity S&P 500 Index Fund (FXAIX) has not generated any capital gains distributions for investors over the past few years. Where, the Fidelity Mid Cap Index Fund (FSMDX) has generated some short- and long-term capital gains, but the impact is significantly less than the FMAGX example above. But as far as the Fidelity Magellan (FMAGX) fund, it’s crucial to understand how an alternative Exchange-Traded Fund (ETF) can provide significantly better tax benefits. Why ETFs Are a Safer Bet According to Morningstar, the Fidelity Magellan ETF (FMAG) has distributed no capital gains to investors over the past few years. This means that by investing in the ETF instead of its mutual fund version, you could prevent $12,880 in triggered taxes on an investment of $100,000… and that’s only in the first year! Although the investments are nearly identical, the tax benefit comes from the structure of ETFs. Because rather than mutual funds that trigger capital gains by selling an underlying investment, ETFs conduct what’s called an “in-kind trade”, meaning they exchange the shares instead of creating a cash transaction. Due to this structure, ETFs have gained significant traction over the past few years, outpacing mutual funds, which have been on the decline. But even with the growth of ETFs, mutual funds still have their place in the market. When Mutual Funds Work Mutual funds shine when it comes to tax-advantaged investing accounts such as IRAs, 401(k)s, or 529 plans, where capital gains distributions do no trigger immediate tax liabilities. For instance, an investor holding FMAGX in a Roth IRA would avoid paying taxes on capital gains distributions (such as the $12,880.14 from the 2023 example above), enabling you to grow your investments tax-free until withdrawal. Depending on your broker, mutual funds may also provide additional features such as automatic investments, fractional investing, or customized dividend reinvestments. SHOW BROKERAGE FIRMS HERE Additionally, mutual funds only trade once per day, when the market closes, which further reminds investors of the value of a long-term investing strategy. Although index mutual funds remain a strong choice for taxable accounts, due to the unknown structure of capital gains distributions, ETFs are the recommended choice. Our Tips for Investing in Taxable Accounts Since the expense ratio, capital gains, and income distributions significantly impact a portfolio’s returns over time, following our recommended tips for investing in taxable accounts could help long-term investors save hundreds of thousands of dollars. Avoid High-Turnover Mutual Funds Aim For Index ETFs Aim For Low Expense Ratios Aim For Low-Dividend Paying ETFs If Dividends, Aim For Qualified Hold At Least One Year Be Aware Of Foreign Taxes Consider Tax-Loss Harvesting The truth is, if you properly invest in the market using taxable accounts, they can be extremely powerful for you. The Power of Taxable Accounts Taxable accounts