Mutual funds must pass through all realized gains to their shareholders. If the fund is held in a taxable account, investors will owe tax, even if those gains are reinvested. Moreover, short-term gains will be highly-taxed as ordinary income.
Even if your fund has a down year, you may owe tax on substantial amounts of passed-through gains. This happened to many people in 2000, when funds sold appreciated stocks that were declining in a bear market, and may happen again in 2001. To avoid such taxes:
Buy tax-efficient funds. Such funds take losses to offset gains.
Buy individual stock. With a buy-and-hold strategy, you won’t realize taxable gains.
Rely upon a money manager. Some managers will pick stocks for you and arrange transactions to minimize the tax bills. In the past, money managers insisted on million-dollar minimums but now brokerage firms and financial planners are arranging professional management for moderate-sized accounts.
