When you buy individual stocks, you get built-in tax deferral. You pay no capital gains tax until you sell your shares. Not so with a mutual fund. Every time the fund sells a stock for a profit, you must pay tax on your share of the profit, even if you have not received any distribution. The gain incurred by the fund may be a long-term capital gain (taxed at federal rates up to 15%) or the fund may have short-term capital gains (taxed at up to 35%). Each year you receive a 1099 form to disclose this phantom income on your tax return and pay taxes on these gains (in addition to the dividends).
Here’s the worst irritation–these taxes are even higher in years when the market falls and investors get scared. More shareholders sell than buy, and the fund will liquidate some of its holdings in order to pay the selling shareholders. The stock sales by the fund often create capital gains that will be reflected on your 1099. So in years when you watch your fund decline in value, you may also get the biggest tax bill!
Here’s an option. Many fund managers also manage sub-accounts within variable annuities.
One great benefit of variable annuities is that you do not receive an annual 1099. Rather, when you liquidate portions of your variable annuity, you will pay tax on the gain at ordinary income rates (up to 35%). But all tax is deferred until you make withdrawals. Additionally, you can switch among sub-accounts with no taxes. (A switch between mutual funds is a taxable event). Note differences between mutual funds and variable annuities—variable annuities have a death benefit, penalty for withdrawal before 59½ and surrender charges may apply.
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