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Chapter 9. Mutual Funds: Carrying the Lo... > What Mutual Funds Give, the Tax Man ...

What Mutual Funds Give, the Tax Man Takes Away

One of the consequences of active mutual funds is the taxable gains they distribute. When a mutual fund manager sells a stock in a portfolio, it will either generate a capital gain or a capital loss. The mutual fund company does not want to pay the income taxes generated from trading activities. Subchapter M of the Federal Income Tax Code allows mutual funds to distribute capital gains, dividends, and interest to the mutual fund shareholders. Toward the end of every year, investors receive these taxable distributions. There are several aspects to this process that adversely affect investors who own mutual fund shares outside qualified retirement plans.

To avoid paying the tax themselves, mutual fund companies must distribute all capital gains generated during the year. These capital gains can be offset by any capital losses incurred. During a bull market year, it is likely that a mutual fund will have much greater capital gains than losses and the investor will receive a large taxable distribution. On the other hand, a bear market year may generate more trading losses than gains. Unfortunately, mutual funds cannot distribute net losses. Net losses are carried over to the next year to offset any gains incurred at that time. This means that in good stock market years, you will have to pay capital gains taxes, but in bad years you will not get the tax-reducing benefit of claiming losses. With mutual funds, distributions are always one-sided: You pay.


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