Mutual Fund Taxes -- What a Drag

As Lipper points out in their April research report, many mutual fund investors were faced with a double-whammy in 2008. Not only were investors faced with a loss due to the stock market, but some investors received capital gains distributions.

This mutual fund tax liability is known as “tax drag.” The trading of stocks (or other investments) in the fund by the fund manager can create capital gains that must be passed through to fund shareholders. Capital gains in 2008? Yes, funds were forced to liquidate long-term positions that had taxable gains because investors were redeeming their fund shares. The fund managers simply did not have a choice, they had to realize gains and pass them through to mutual fund shareholders.

On the other hand, many fund managers were able to sell stocks at a loss resulting in tax-loss carryforwards. These tax losses will offset future taxable gains in funds, resulting in lower capital gains distributions. This is good news for fund investors, particularly for fund investors with active mutual funds in taxable accounts -- where the tax burden can weigh down returns.

Morningstar has an excellent tool to analyze the potential capital gains exposure in your funds. Simply type the fund symbol in the quote box and click the “Tax Analysis” tab.

Oh, and don’t let anyone fool you, taxes, along with costs, should be an important consideration when evaluating mutual funds held in a taxable account.