Like brushing their teeth, some people need to check their mutual fund account balances on a daily basis. About this time of year, some will have a reason to be startled when checking a mutual fund to see a one-day drop of 20 percent or more. Huh? What happened?
Mutual funds trade stocks during the course of a year, and in successful years when results are positive on average, they create capital gains, or profits, which are described as "distributions." When those distributions are paid out, the share price drops by the value of the gains. Until the payout, the gains had been reflected in the steadily increasing share price of the fund.
Not to worry. While the share price drops on the day of the payout, the dollar amount of the payout buys an equivalent amount of the new shares at the lower, new-share price. The dollar amount of one's investment in that particular mutual fund account will remain constant short of any actual changes in the values of the underlying share prices in the fund.
Meanwhile, the process of making the distribution and using the money to buy new shares takes a few business days, so it's important to understand that the heart-stopping 20 percent loss is only temporary. For most people who only look at statements every so often, it would be a coincidence to be checking an account during the two-day period that a distribution was in limbo. Just bear in mind that the distribution used to purchase new shares will be taxed as capital gains for this year. Unless you want to sell some of the account, you will have to find the money from somewhere else to pay the tax that will be owed -- both federal and state.
All of this is academic to anyone whose mutual funds are in retirement accounts of any type, because there are no taxes to be paid on earnings in a tax-sheltered account. The only tax ever paid on money in a retirement account occurs when money is distributed to provide retirement income (or to provide a safety net when between jobs).
But many people actually have investments that are so-called "after-tax" investments. Savings, inheritances, money resulting from the sale of a home or a business, are all sources of what become taxable investments. The right selection of investment tools can help reduce or control the tax problem cited above.
For example, when you buy a mutual fund for $1,000 and sell it seven years later for $2,000, you would pay a capital gains tax on your $1,000 profit. However, during the time you have owned a fund fortunate enough to have made profitable trades during your ownership period, the fact that you have paid at least some taxes on those trades from year to year is taken into consideration when you sell the fund. In this example, you may have already paid taxes on $500 of your $1,000 profit. Until 1986, the fund industry left people to their own devices to make these calculations, but today the fund companies keep track of your original purchase price and the capital gains you have experienced and paid taxes on from year to year.
A typical actively managed fund will have "turnover" of 50 percent or more. This means that half of the stocks owned at the beginning of the year will be sold by year-end. Some turnover can be as high as 200 percent, which means that by June all the original stocks have been replaced -- and those replaced again by December.
Turnover, when it's successful, is what triggers these annual capital gains distributions. If the mutual fund does little or no trading and the share prices of the underlying companies rise, the capital gains within the fund are "UN-realized" and investors just sit there watching their investment value rise without having to scramble to find money to pay capital gains taxes. A typical index fund investing in a broad cross section of stocks and leaving them alone, like a 500 index fund, will have a negligible 3 percent turnover. When your $1,000 rises to $2,000, you pay capital gains tax on just the amount you feel like selling. In other words, you control the timing of when you pay the tax. By comparison, paying taxes on an ongoing basis because of turnover typically turns a 10 percent market return into an 8 percent after-tax return, and this explains why managed money does such a poor job of beating market averages. Beyond index funds, another approach is to invest in individual stocks and not trade them.
With a five-year bull market, even the most incompetent fund managers have made money this year, so many investors will be receiving substantial tax bills for profits they never knew they had. As problems go, it's a delightful one to have, but there are ways to avoid it and to wind up with a lot more money in the end.