How mutual funds & ETFs are taxed
The investment tax you owe depends both on your own buying and selling and on that of your funds.
POINTS TO KNOW
- At least once a year, funds must pass on any net gains they've realized.
- As a fund shareholder, you could be on the hook for taxes on gains even if you haven't sold any of your shares.
Funds buy & sell too
But you may also owe taxes if the fund realizes a gain by selling a security for more than the original purchase price—even if you haven't sold any shares. By law, the fund must pass on any net gains to shareholders at least once a year.
What happens when a fund passes on gains?
This could lead to several scenarios that might surprise you.
- In a down market, shareholders often take money out of funds, meaning the fund manager has to sell some of a fund's holdings to meet demand. If the fund sells lots with large built-in gains, this could lead to net gains, which you'll be taxed on—even if your fund's share price went down during the year.
- Also, you might buy shares of a fund that realizes capital gains soon after your purchase—in which case you'll owe taxes on these gains even if you haven't been invested long enough to benefit from them.
- On the flip side, capital gains are considered to be short-term or long-term based on how long the fund held the securities being sold. So even if you recently bought into the fund, you'll pay the preferential long-term capital gains rate (as long as the fund held the securities for more than a year).
The bottom line
If taxes are a concern for you, it's a good idea to look into a fund's unrealized capital gains before investing a large amount and to find out whether a capital gains distribution is imminent.
You also may want to consider investing in index funds, which tend to buy and sell less often, leading to fewer realized gains and losses.
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How investments are taxed
A single unit of ownership in a mutual fund or an exchange-traded fund (ETF) or, for stocks, a corporation.
A type of investment that pools shareholder money and invests it in a variety of securities. Each investor owns shares of the fund and can buy or sell these shares at any time. Mutual funds are typically more diversified, low-cost, and convenient than investing in individual securities, and they're professionally managed.
A type of investment with characteristics of both mutual funds and individual stocks. ETFs are professionally managed and typically diversified, like mutual funds, but they can be bought and sold at any point during the trading day using straightforward or sophisticated strategies.
Capital gains that are now taxable because the investment has been sold at a higher purchase price than what was originally paid.
Shares acquired in one transaction. You can own multiple lots of an investment if you acquired shares of the same security at different times.
Capital gains that are "on paper" only because the investment has increased in price since the original purchase, but hasn't yet been sold for a profit.
A type of fund that seeks to track the performance of a particular market index by buying and holding all or a representative sample of the securities in the index, in the same proportions as their weightings in the index.