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The Dangers of Embedded Tax Liabilities in Mutual Funds

July 30, 2008

This post continues a discussion I’ve forwarded about the inadequacy of current mutual fund disclosure regulation. In a previous post I’ve talked about the need for additional disclosure about mutual fund fees.  Now we turn our attention to taxes, and how unsuspecting mutual fund investors can be saddled with a tax bill they had no part in creating.

If you hold shares in a mutual fund outside of a tax-deferred retirement plan you no doubt receive information each year on the amount of money the mutual fund distributed to you in the form of taxable dividends and/or capital gains. For a detailed explanation of how mutual funds create tax liabilities click here. What mutual funds are not required to disclose is their potential capital gains tax liability. And at risk of boring you to tears I am going to provide a simple example so that (hopefully) it is clear why this matters.

Suppose a mutual fund company currently owns two shares of the company HiTech. The shares were purchased by the fund at $5 per share and are currently selling for $10 a share. The fund has issued two shares of its own, owned by Bill and Mary. The current net asset value per share of the fund is thus $10 per share.  Now suppose Ron buys a share of the fund for $10. The fund uses the proceeds to buy another share of HiTech. The fund now owns three shares of HiTech with acquisition costs of $5, $5 and $10.

Now suppose the stock of HiTech drops to $9 per share. This drop causes the net asset value per share to drop to $9. Bill and Mary decide to redeem their shares. To meet this redemption, the fund sells two shares of HiTech with the cost basis of $10 for one share and $5 for the other. This generates a realized capital gain of $9-$5 = $4 for the share purchased at $5 and a realized capital loss of $1 for the share purchased at $10. So, there is a net captial gain of $3. This capital gain must, by law, be distributed to the remaining shareholders. So, in this case, Ron recieves a capital gain distribution of $3. The net asset value of the fund falls to $6 per share and, assuming reinvestment, Ron now owns 1.5 shares.

Although Ron has experienced an investment return of -10%, he will still face this capital gains tax. If capital gains are taxed at 15% he must pay 45 cents in taxes. So, even though Bill and Mary walked away with the investment returns, Ron gets left holding the tax bag and must pay the federal goverment the taxes that Bill and Mary’s investment returns created.

Some mutual funds, particularly equity mutual funds, have large embedded tax liabilities of just the short described here. If they needed to sell assets quickly to generate cash those who did not exit the fund right away would be stuck holding the tax bag. Most people don’t know much about what I’ve just written here, but you can bet that if it happened at large enough scale (like during a sizable economic downturn) the press would quickly notice it and that investors would quickly exit these mutual funds — in a way not altogether different than a bank run — to avoid these tax implications.

At a minimum, individuals should be given information sufficient to determine whether a fund they are thinking of investing in has a large or small embedded tax liability. Without this disclosure, there are serious and often-unknown financial risks to savings invested in mutual funds. The SEC should mandate this disclosure. If they do not, the House Financial Services Committee should write legislation requiring the SEC to do so.

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4 comments

  1. Nice writing. You are on my RSS reader now so I can read more from you down the road.

    Allen Taylor


  2. As an investor in mutual and index funds I agree that the SEC should get involved in mandating these disclosures. However, the anti-regulation crowd is pretty powerful in Washington and I doubt this will happen anytime soon.


  3. Thank you for the valuable information. I’m not sure if it applies to my investments or not. Can you tell me (the average layperson)what the first step would be to find out if I’m dealing with these types of mutual funds?


  4. Also,be extra careful with international and emerging market funds. They had a lot of redemptions in 2008 and will be paying high distributions. Some firms will be better than others at making investors aware.



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