How mutual funds & ETFs are taxed
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.
This information is general and educational in nature and should not be considered tax and/or legal advice. We recommend that you consult a tax or financial advisor about your individual situation.
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