Investing in mutual funds can create tax headaches. When you invest in a fund you’re assuming the fund’s cost basis in each of its holdings, many of which may have appreciated. Suppose, for example, you invest in ABC Growth Fund in July 2001. At that time, ABC holds $1 million worth of XYZ Co. stock, acquired at a cost of $300,000.
In August 2001, XYZ Co. reports bad news and the stock falls by 20%. ABC Growth Fund’s manager sells the stock, now worth $800,000.
Even though you actually have lost money on this holding, the fund has a $500,000 gain: bought at $300,000, sold at $800,000. That gain will be passed through to all shareholders, pro rata, and you will owe tax on the distribution. You’ve lost money yet you have a tax bill.
One way to avoid this tax trap is to avoid mutual funds. You can buy individual stocks and hold them indefinitely, never incurring taxable gains. When you buy individual stocks, you can time your sales-and your tax bills. Alternatively, you can invest in a “tax-managed” mutual fund, which will try to offset any trading gains with losses from other holdings.
