Taxes and Mutual Funds

A common measure of a mutual fund’s trading activity is its
turnover rate, which is expressed as a percentage of the fund’s
average net assets. For example, a fund with a 50% turnover rate
has (over the course of a year) sold and replaced securities with a
value equal to 50% of the fund’s average net assets. This means
that, on average, the fund holds securities for two years. (The
average turnover rate for U.S. stock mutual funds is about
113%.*) Turnover rates can’t be used to forecast a fund’s taxable
distributions, but they can help you compare the trading policies
among funds. Assuming that a fund’s holdings will increase in
value over time, you need to consider how much of that increase
in value will be passed along to you as a taxable capital gains
distribution. The fund’s turnover rate bears directly on this point.
A capital gain on the sale of securities is a realized gain. In
contrast, an unrealized (“paper”) gain has not yet been locked in
by the sale of securities. For example, a fund may have bought
stock in XYZ Inc. for $5 per share three years ago. If the stock’s
price rises to $15, the fund has an unrealized capital gain of $10
per share on XYZ’s stock. As long as the fund continues to hold
the XYZ shares, there is no taxable gain. But if the fund actually
sells the stock at $15 per share, shareholders will usually have to
pay taxes on the $10 per share of realized capital gains,
regardless of whether the shareholders owned their own shares
in the mutual fund for a month or for a decade. Thus, all
unrealized capital gains have the potential to be converted
eventually into realized capital gains.
This means that you should consider both a fund’s realized and
unrealized gains (information that is available through your
mutual fund company) and also its turnover rate to determine
the potential tax implications of your investment.
*Source: Lipper Inc.
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