Mutual Funds Can Have Tax Shocker But ETFs Don’t

Both mutual funds and exchange traded funds (ETFs) have taken their licks in the downturn, but mutual funds are about to start adding insult to investor injury.

Even though the average U.S. diversified stock fund is down 33% through Monday, investors might find themselves having to pay big tax bills anyway, reports Tom Herman for the Wall Street Journal.

Mutual funds generally pay net capital gains to investors at the end of each year, and they’re typically taxable if the investments are held in a taxable account. But even though the market has been in a free-fall for much of this year, investors might be receiving capital gains distributions anyway.

There have been so many redemptions in mutual funds that managers are finding themselves digging into their low cost basis stocks to meet these redemptions.

Herman suggests that investors either exit before getting saddled with a capital gains distribution, and those investors getting in ought to make sure that there won’t be one. The last thing anyone wants is a surprise tax bill.

This just kicks investors while they’re down, forcing them to pay taxes when their holdings have already declined substantially. With ETFs, though, this isn’t an issue, as their tax efficiency is one of their primary selling points. Capital gains aren’t paid until a fund is sold, so there are no surprises.

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