The Investment Scientist

Advanced Taxation of Mutual Funds

Posted on: December 15, 2019

km1-taxation-in-germany.jpgThe following is a hypothetical but highly realistic example of mutual fund advanced taxation. You invest $100,000 in a stock mutual fund on Dec 20th. You get a distribution of $10,000 on Dec 23rd. The distribution is reinvested. When you go check your account balance at year-end, the account balance has gone down a little to $99,950. No big deal.

In January, you get a 1099-DIV form from the mutual fund company showing you have dividend income of $2,000 and capital gains of $8000. (They add up to $10,000). You have to pay taxes on those! You jump from your chair: “What! I lost money in the investment, and I have to pay taxes on income and gains I don’t see?! What gives?”

It turns out that mutual funds are required by law to distribute any dividend incomes and all net capital gains by year-end. Usually, they have a record date in December. If you are a fund-holder on record at that time, you will receive the distributions. Most mutual funds have their record dates fall between December 10 and December 20. The distributions come at a cost. After the $10,000 distribution, your fund balance becomes $90,000. But unless you otherwise specify, the distribution will be reinvested back to the fund, so your fund balance goes back up to $100,000. Nothing has changed, right? Wrong!

You have to pay taxes on the $10,000 distribution. On the other hand, now your investment basis is the initial $100,000 plus the reinvested $10,000 equaling $110,000. Since your fund account balance is only $100,000, you have a $10,000 unrealized loss on your investment. All of this happens between the record date and the distribution date.

You can sell your investment by year-end to realize the $10,000 loss to offset your distribution gains, or you will have to pay taxes on the $10,000 distribution: income taxes on the $2000 dividend incomes, and capital gain taxes on the $8000 capital gains. If you are in the highest tax bracket in a high tax state, you pay 50% on your income and 20% on your capital gains. In total, you will pay $2600 in taxes. Needless to say, advanced taxation is quite costly to investors.

Or is it? Maybe not, since the $2600 you pay now is $2600 you don’t have to pay in the future. My next article will investigate how costly advanced taxation is over the life cycle of investment.

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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