The Problem with Mutual Funds especially in Non Qualified Accounts and Taxation

As I am already starting to close out my books for the year, and prepping for 2017 to roll in, I wanted to bash on the mutual fund industry for a moment (partly because it’s just too fun and easy).  Also, I want to give a warning to one of the biggest problems with investing in mutual funds that doesn’t get a whole lot of attention, but really should.

First of all, I’m not a fan of prepackaged investment products.  Be it mutual funds, ETFs, or annuities.

  • I don’t like actively managed mutual funds because most of them will underperform their respective benchmarks over the long haul
  • Commissions! Why would you hand over hard earned money and pay a rip (broker slang for commission) on it.  If the cock sucker in the suit says don’t worry, you’re not going to pay a fee and tries puts you in a B or C share class… kick him in the balls for trying to screw you over.
  • The management fees/expense ratios are too high, thereby taking money out of your pocket
  • I hate how these companies say invest for the long haul, yet their own investment strategies are very short term
  • I’m not a fan of ETFs either.  I want to beat the benchmarks not simply match the benchmark (technically underperform a little)
  • Annuities just fucking suck.  Anyone tries to sell you that shit, punch them in the face and walk out.

Honestly, if I had to choose one of the above… ETFs are the better option to go for someone not comfortable investing in individual stocks (or just Vanguard Funds).  At least the fees are low so you won’t underperform by a large margin, and also because indexing is not 1:1 perfect, there are occasional days you can slightly outperform the benchmark.

So aside from the above reasons, another one not talked about much is taxation.  Yep taxes on your mutual fund investment.

For someone investing in mutual funds inside of your 401(k), Roth or Traditional IRA, this doesn’t apply…taxes are deferred until withdrawal or non-existent in the case of a Roth.  High fees still apply though.

Where taxation sucks on mutual funds is in what’s called a Non- Qualified Account.  These are just regular investment accounts you would set up as an individual or joint account.  Think of it like this…those types of account registrations are not qualified for special tax treatment.

There are 2 ways taxation occurs on mutual fund transactions.

First- Just like purchasing shares of stock.  You buy CLX at $110 per share and sell later at $120, you owe a capital gains tax on that $10 appreciation.  It could be short term or long term capital gains, depending on your holding period.  So if you purchased shares of a mutual fund, you have the same thing happening.  Purchase share of a mutual fund at $10, sell at $11, you owe a capital gains tax on that $1.  These are realized capital gains.  Pretty simple, right.

Second- And this is the real bitch…Unrealized Capital Gains.  These are gains that you owe taxes on for the year, even though you DO NOT sell shares.  What?  Inside of mutual funds, there is trading activity going on quite frequently.  This is referred to as turnover.  Turnover of 100% means the entire portfolio is comprised of new holdings.  Turnover of 1% means very little change in holdings (you’re probably in an index fund).  So as mutual fund managers are trading stocks inside of their fund, gains and losses are racking up in their accounting in the fund.

This is bad for investors for a couple reasons.  Say you invested at the start of the year in a mutual fund with a NAV (price) of $10.  You are in an actively managed fund the advisor sold you on.  The market is humming along, goes up nicely mid way through the year, the NAV on your mutual fund is $12.  Everyone is happy.  All along, trading has been taking place and you have not taken any money out of the account.  Let’s say the second half of the year, the market tanks, and you close at $10 per share on your mutual fund.  You broke even for the year and never took out money.  At least you broke even, right?  Hold your horses.  Because of the trading going on within the fund you could still face unrealized capital gains.  Let’s say that unrealized gain is $1 per share.  Even though your account is sitting at even, you never took money out or sold shares.  You would owe a mixture of short/long term capital gains on that unrealized capital gain.  This would amount to taxes starting at $0.15 and up.  Doesn’t sound like much, but who invest only $10.

With individual stock investing, you control your taxation.  Don’t want to pay taxes, don’t sell anything.  Want to protect your gains, but not sell this year…you should read my protected put article.

Another horrible thing that happens, and my warning as the year end nears… those unrealized capital gains can impact an investor who drops a lump sum into a mutual before the date of record.  Let’s say you put a large sum of money in your mutual fund investment on December 20 (say $100,000). The date of record is December 23.  You are invested for 3 days. Let’s say your account value doesn’t change or hell even goes down a little.  Since you invested before the date of record, you participate in the unrealized capital gains for the year. Nobody cares that you’ve only been invested 3 days.  Let’s also say you went into a high turnover fund, where there was a 10% capital gains distribution.  Suddenly you have a personal phantom gain of $10,000 that you will owe taxes on.  This means a tax bill of at least $1500 and going up, depending on the mixture of short and long term gains in the fund.

The same example above can happen in  a sharply down year for the markets and investing in mutual funds.  Customers don’t understand in a year like 2008 how they are owing taxes, when their investment went down for the year.  It’s these unrealized capital gains.

I have seen this stuff happen.  I’ve seen untrained advisors do the above scenario of investing $100,000 just before the record date at the end of the year.  In February, that customer called the broker back and chewed out the advisor (and he deserved it too.  The customer was going have a tax bill of a few grand and no real gains to show for).  I personally held customers back from doing this stuff, when I was in the game.  Having a pissed off customer wasn’t worth the quick sale to me, plus building that trust factor will always result in more sales down the road and bigger bonuses later on.

So my warning to mutual fund investors (especially those thinking about dropping a nice lump sum at the end of the year), think about the tax implication first.  Find out that record date, and invest after those capital gains distributions take place.  You should also look into low turnover funds, index funds, or ETFs.  Taxes shouldn’t always be what dictate your investment, but this stuff should have an impact on your decision.  One slick (and stupid) thing I’ve heard customers told about unrealized capital gains, “don’t worry, you cost basis will adjust”.  True, but that still doesn’t make a difference on the taxes that YOU will have to pay.  It’s more of a line being fed to you to get your ass off the phone.

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Readers Comments (46)

  1. I always wondered why Unrealized Capital Gains mattered. Thanks for the explanation.

    • I always dreaded that time of the year working in the industry… management trying to get you to produce more sales last minute, at the same time I’m not trying to piss off customers by screwing them over. April 15th was always rough as well.

  2. This is a very good explanation, thanks. I’m exclusively invested in index funds, but this is good to know.

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