Everyone’s heard of mutual funds. They’re companies that pool money from many individual and institutional investors to buy and sell a variety of securities and assets, such as stocks, bonds, money markets, real estate, and precious metals. A mutual fund’s holdings are called its portfolio and each investor owns shares, which are a portion of the portfolio. When you buy or sell most mutual fund shares, you do it directly with the fund family. A few of the best-known mutual fund families are Fidelity, Schwab, and Vanguard.
The Pros of Investing in Mutual Funds
When you own shares of a mutual fund, the benefit is that you have a convenient, well-diversified package of many individual investments that would be complicated for the typical investor to manage on their own. Mutual funds are professionally managed and give you the ability to invest small or large amounts of money, even if you don’t have much financial or investing experience.
The Cons of Investing in Mutual Funds
The pros sound great, but there are some important cons of investing in mutual funds to keep in mind:
- Most charge fees. Mutual funds can be expensive to operate. That’s why investors get hit with annual fees and sales commissions regardless of a fund’s performance. However, there are some no-load funds that can minimize management fees.
- Share prices are calculated just once a day. A mutual fund is different from a stock where you can monitor price changes minute by minute, if you like, by checking Web sites like etrade.com or scottrade.com. Since a mutual fund is made up of multiple securities, its price depends on the fund’s net asset value or NAV which is calculated at the end of the trading day. When you put in an order to buy or sell mutual funds, the price is unknown until the financial markets close.
- Capital gains of the fund get passed along to shareholders. U.S. tax law requires mutual funds to distribute capital gains to their shareholders. These distributions are taxed at the long-term capital gain rate, no matter how long you’ve owned the shares.
Capital Gains and Mutual Funds
One the biggest cons of owning a mutual fund is something called a phantom gain. A phantom gain gets its name from the fact that you can lose money on an investment, but still owe taxes—which is a real bummer! Phantom gains are common in a down market and can occur when investors decide to sell a declining mutual fund. When investors sell their mutual fund shares, the fund company might need to raise cash in order to pay them. In some cases, the fund might have to sell some of their investments—even profitable ones. Selling profitable investments creates a capital gain, which is taxable and unfortunately gets passed along to the fund investors.
The way capital gains work with mutual funds is very different than with an individual security, such as a stock. When you own a stock, you pay tax each year on any earnings you may receive, such as a dividend. But you don’t pay capital gains tax until you actually sell the stock and bank a profit. With mutual funds, this same information is true. But in addition to paying capital gains tax on shares you sell and profit from, you also have to pay taxes each year on the fund’s capital gains.
How to Defer or Eliminate Mutual Fund Taxes
One way to defer taxes on mutual fund distributions is to own the fund inside of a retirement account, such as a traditional IRA or 401(k). These accounts enjoy tax-deferred growth, which means your profits within them aren’t reported as capital gains. You don’t get hit with any taxes until you make a distribution from a traditional retirement account after the age of 59½. At that time your profits are taxed as ordinary income, not as capital gains.
Another option is to own mutual funds inside of a Roth IRA or Roth 401(k), which are tax-free retirement vehicles. You pay taxes upfront on money you put in a Roth account, but the growth is completely tax-free. That means you could use a Roth account to completely eliminate taxes on mutual fund distributions.
If you own mutual funds outside of a retirement account, be prepared for any possible tax liability this year. Many mutual funds end their fiscal year at the end of October, so be on the look-out for their distribution estimates so you can plan accordingly. See IRS Publication 564 for in-depth information about the taxes associated with investing in mutual funds.
Finally, if you’re looking for a way to start buying mutual funds, you can always consider a number of the current hot brokerage firms. Some of these are Personal Capital, Wealthfront, and Betterment. Modest Money has a pretty good review of Betterment, so check it out if you get a chance.
For how to get started with buying mutual funds, how to pick the best, and when to sell check out these amazing articles.
(Photo by scottwills)