Taxes Generated within Mutual Funds or ETFs

By Financial Advisor Peter Egolf

When reviewing the investment costs, an attuned investor will recognize a mutual fund or exchange-traded fund's (ETFs) expense ratio as the price paid to generate the fund's investment returns. Therefore, a higher expense ratio will have a more significant drag on gross returns. The expense ratio or cost of operating the fund is taken directly from the returns, and investors often see return values and charts net of these expenses. An investor looking to lower their investing costs will utilize vehicles, such as index investments, with low expense ratios. However, a less obvious and often overlooked cost omitted from the expense ratio is the fund's tax cost.

The key indicator for understanding your mutual fund or ETF's tax cost is called "Turnover Rate." The turnover rate is the percentage of individual holdings within the fund that changed (were bought or sold) that year. Actively managed mutual funds and ETFs will have higher turnover rates due to the manager buying and selling holdings within the fund in an attempt to seek greater returns. (Learn more here.) Passively managed or index investment mutual funds and ETFs will have lower turnover rates, as fund managers only rebalance when the companies included in the index change (e.g., companies that enter and exit the S&P 500). As you may have guessed, the higher the turnover ratio, the greater the potential tax consequences. Thus, two mutual funds/ETFs with equal returns, equal expense ratios, and different turnover ratios may yield different net returns.

Taxes strengthen the argument against actively managed funds. Actively managed funds are by name and nature, active. Thus, actively trading the positions within a mutual fund or ETF can result in a taxable event in the form of capital gains: short or long-term. If a fund manager sells a position within the fund within one year of purchase, the sale will result in investors realizing a short-term capital gain or loss on their income tax return. Short-term capital gains, and ordinary dividends, are taxed at federal ordinary income tax rates. Long-term capital gains occur at the time of sale when positions are held for longer than one year. Long-term taxable gains, and qualified dividends, are taxed at predefined federal tax rates (0%, 15%, or 20%) based on your income level¹. Your place of residence will determine whether you are also liable for state and local capital gains taxes².

These taxable events are out of the individual investor's control and can manifest in two unfortunate and one beneficial situations. First, when other investors take money out of a fund in a down market, a fund manager may be forced to sell positions with gains to rebalance the fund³. Thus, the individual investor has the potential to see both losses in the value of their investments and a subsequent tax bill.

An even more frustrating situation comes as a result of timing. A fund manager can decide to distribute gains at any time³. Thus, an investor has the potential to purchase a new investment, and the fund may realize previous short or long-term gains at any time. Therefore, the investor will realize gains and a tax bill for returns they did not receive. Investing and timing may be dance partners, but they are not always friends (and you know how that works out).

Alternatively, an individual investor can benefit from a new investment purchase, which recognizes gains of long-held securities in the form of long-term capital gains, despite having owned the investment for a short period.

The key takeaway? Trading activity inside a mutual fund or ETF creates potential tax consequences that flow through to your personal tax Form 1040, Schedule D.

1. https://www.irs.gov/taxtopics/tc409
2. https://worldpopulationreview.com/state-rankings/capital-gains-tax-by-state
3. https://investor.vanguard.com/investing/taxes/mutual-funds-etfs