My Fund Dips, I Owe Taxes?

The market is choppy lately, and if this is the precursor to a swoon, brace yourself for an annoying paradox: Your taxable mutual funds slip in value, but the government still taxes you for capital gains that your funds recorded.

Large swings within the market are more common than many of us would like. As investors see increased volatility, their natural reaction is fear, which can lead to emotional investment decisions. Result: large withdraws from mutual funds.

Fund mangers often have to sell stocks and other securities they hold to meet investors’ redemption requests. There is much confusion regarding mutual fund taxation. One thing that bamboozles many investors: Even if they don’t cash out of a fund, they get a 1099 tax form for gains inside of the mutual fund.

They owe taxes on what often are referred to as phantom capital gains. You buy a fund with a $10 net asset value, and you own a unit of it. Some people think that you own the underlying shares held inside the mutual fund, but that is not accurate.

Let’s say you have a great manager who bought ABC shares in January for $25 a share. The market has a great run and suddenly ABC is trading at $40 per share. You invest in the fund in June at $10 per unit.

Then after you buy into the fund, there is big market volatility. Your fund units fall to $8, but you don't sell.  You have a realized loss on paper but not a recognized loss since you didn't unload the fund. Some of your fellow investors do sell and your mutual fund has to raise cash.

ABC falls from $40 to $35, and the manager sells ABC shares to raise cash to take care of fleeing investors. The ABC stock is less today than when you bought into the fund, but the fund bought the shares at $25, which means they have an internal gain. As an owner of the fund, you get to recognize that gain on your tax return. Congrats.

Hold on. Since the fund came out ahead on ABC when it sold those shares to cash out departing investors, the Internal Revenue Service taxes you on that phantom gain. Meanwhile, though, the overall fund is down. What an irony.

This is important in volatile and questionable markets. It has happened before, and it’s likely to happen again. Late in 1999, the market turned ugly and some investors sold, producing capital gains inside of mutual funds. You get a tax bill due the next April.  The problem is the tech wreck started in March 2000 and you were now paying taxes on money you no longer had due to the market correction. That's a double whammy.

The point here is not to tell you the market is collapsing. The double whammy does not apply to retirement accounts like 401(k)s, where you pay taxes only when withdrawing money. But you do need to know that volatility can lead to more than just excitement and frustration.  Volatility creates taxation. Stick to your plan and also understand your exposure to both risk and the IRS.

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Joseph “Big Joe” Clark, CFP, is the managing partner of the Financial Enhancement Group LLC, an SEC Registered Investment Advisory firm in Indiana. He teaches financial planning at Purdue University and is the host of Consider This with Big Joe Clark, found on WQME and iTunes. He is a Registered Principal offering Securities and Registered Investment Advisory Services through World Equity Group, Inc, member FINRA/SIPC. Big Joe can be reached at bigjoe@yourlifeafterwork.comor (765) 640-1524. Follow him on Twitter at @Big Joe_Clark and on Facebook at http://www.facebook.com/FinancialEnhancementGroup.

Securities offered through and by World Equity Group Inc. Member FINRA/SIPC. Advisory services can be offered by the Financial Enhancement Group (FEG) or World Equity Group. FEG and World Equity Group are separately owned and operated.
 
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