NCPA - National Center for Policy Analysis

How Taxes Eat Away At Mutual-Fund Profits

August 31, 1999

Mutual funds with high portfolio turnovers drive up investors' taxes, experts point out. Morningstar Inc., a market research firm, estimates that investors in diversified U.S. stock funds surrendered an average 15 percent of their annual gains to taxes over the five years ended July 31. This figure reflects the taxes paid on fund distributions -- but excludes the taxes owed upon selling a fund.

  • A typical U.S. stock fund has a turnover rate of 100 percent a year.
  • Every year, a fund is required by law to pass along to investors virtually all dividends and realized capital gains, in the form of income and capital-gains distributions.
  • Thus, a high-turnover fund increases shareholders' tax exposure much beyond that experienced by people who buy individual stocks and hold them, or investors in index funds -- which don't actively trade stocks, but simply attempt to mimic the performance of a particular stock index.
  • David Stein, of Parametric Portfolio Associates, says that the manager of a fund with a 100 percent annual turnover rate must beat the market by 2.5 to 3.5 percentage points every year to match the post-tax returns of a comparable index fund.

One way an investor in a high-turnover mutual fund can escape the clutches of the Internal Revenue Service is to put his shares in his 401(k) retirement account, experts recommend.

Source: Jonathan Clements, "How the Taxman Dines on Your Fund," Wall Street Journal, August 31, 1999.


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