When you invest in mutual funds, you owe
income tax on gains in the fund.
Short-term gains
Each time a mutual fund sells an investment
for more than the fund paid to buy it, the fund realizes a
capital gain.
And those gains are passed along to the fund's investors
in proportion to the number of shares in the fund that the investor
owns.
Most actively managed funds don't wait
more than a year before selling investments. That means that any
profit on the sale is a short-term capital gain, which is taxed
at your regular tax rate. And since a fund typically doesn't
withhold tax on your behalf, as an employer does, you must come
up with the amount you owe from other sources if you don't
want to sell shares — at a potential additional gain —
to raise the money you owe.
Phantom gains
As a mutual fund shareholder, you owe income
tax on all the gains the fund realizes. For example, if a fund
bought stock in a company when it was inexpensive and held it
several years until it had gained significantly in value, the
fund would have a long-term capital gain to distribute to shareholders.
But if you had purchased your shares after
the stock price increased, with the resulting increase in the
fund's
net asset value (NAV),
our taxable distribution could
be larger than the total return on your investment.
