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By Russel Kinnel | 04-09-2015 02:00 PM

Funds Facing a Tax Overhang

High potential capital gains exposure, high turnover, and investor redemptions can mean higher tax bills for fundholders.

Christine Benz: Hi, I'm Christine Benz for The year 2014 was a tough year from the standpoint of mutual fund capital gains taxes. Joining me to discuss this topic is Russ Kinnel--he is director of fund research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Good to be here.

Benz: Russ, let's start by talking about how mutual fund taxation works. In some respects, it's just like if you held any other security--an individual stock, say. So, if I sell the security and I had a gain in it over the period that I held it, I pay taxes on that. I also pay taxes on income distributions, just as would be the case if I owned an individual bond or whatever. But let's talk about these capital gains taxes. These are the ones that investors don't exert a lot of control over. Let's talk about how they work and also why the past few years haven't been so great from the standpoint of these big capital gains payouts.

Kinnel: The capital gains taxes are really the part in mutual funds where it's a little weird. It's unusual because funds are required to distribute their capital gains. So, if [their sales of stocks] have led to a profit, they distribute that capital gain to shareholders. And then shareholders, as of that capital gains date--usually it's one of the last few days of December--have to pay taxes on it the following April.

What's unusual, though, is it doesn't matter what your own tax position is. So, someone who bought the fund, say, Dec. 1, 2014 gets the same tax bill as someone who bought it 20 years ago and actually built up much more capital gains. So, it's a really weird quirk and, as you say, you don't really have much control over it. Once you are a shareholder on the date in which they pay that gain out, you're paying taxes on it.

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