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 20%) or the fund may have short-term capital gains (taxed at up to 39.6%). Each year you receive a 1099 form to disclose on your tax return and you 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 fund investors create net redemptions in the fund. When more fund shareholders want to sell than buy (which usually happens when the market is falling and investors get scared), the fund will sell its holdings in order to create cash to pay the selling shareholders. These sales by the fund of its stocks often create capital gains and these 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.
The great aspect 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 39.6%). 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).
To learn more about mutual funds, avoiding mistakes and saving taxes, check the attached form to get a copy of “Avoid Mistakes in Selecting Mutual Funds.”
Note differences between mutual funds and variable annuities—variable annuities have a death benefit, penalty for withdrawal before 59½ and surrender charges may apply.