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Slate's Wall Street Self-Defense: Mutual Fund Taxes


This is DAY TO DAY. I'm Madeleine Brand.

Monday is the deadline to file your tax return. And if you own shares in any mutual funds, you may be looking at your tax return this week and wondering why you're paying so many taxes on your investments. The pre-tax performance of a mutual fund, the number that companies tout, is almost meaningless compared to its after tax returns. And that's where many mutual funds fall down.

Joining us to explain how this affects you is Henry Blodget. He writes on the financial industry for the online magazine Slate.

Hi, Henry.

Mr. HENRY BLODGET (Financial Contributor, Slate Magazine): Hi. Thanks for having me.

BRAND: You're welcome. Well, first of all, where do I, as an investor, find out which taxes I'm paying on a mutual fund? Are they on the tax statements?

Mr. BLODGET: They'll be on your tax statements. You won't actually see them on the return letter that you get at the end of the year describing how the mutual fund did. But then, when you get your tax statements, that is where you will find exactly how much money you have to cough up from your own pocket, in order to pay the taxes on the fund.

BRAND: And that's kind of a surprise, because from the mutual funds' perspective, they're doing pretty well.

Mr. BLODGET: They are often doing well. Taxes definitely have a very detrimental effect, especially if the fund tends to trade a lot. Usually, that generates a lot of tax.

BRAND: Tell us about that. Why is that?

Mr. BLODGET: Well, there are short-term capital gains taxes and long-term capital gains taxes. And short-terms, the taxes tend to be much higher. It obviously depends on what tax bracket you're in. But if your fund is a fund that likes to try to make rapid trades and make money quickly, they're going to generate a lot of short-term capital gains tax. And so that will result, ultimately, in a big tax bill for you.

BRAND: Do some funds do better than others tax wise?

Mr. BLODGET: Some funds are much better than others. Index funds; obviously, there are a lot of studies show that index funds generally do better than actively managed mutual funds, where stock pickers are trying to trade in and out of the market very quickly. But one other advantage that they have is, on the tax side, because they don't trade as much usually, they tend to be much more tax efficient. So, after tax, they look even better.

BRAND: Well, if it's better for funds not to trade so much, why do fund managers trade so much?

Mr. BLODGET: Well, there we go. Now you're getting to the heart of the matter. The--I would say the main reason is that the mutual fund industry is tremendously competitive. And fund managers are scrutinized for their weekly and monthly and quarterly performance relative to their competitors. And all of that is on a pre-tax basis. So, if you want to survive as a fund manager, you really have to focus on pre-tax. Now, unfortunately, for the end investor, that means often that you get a much larger tax bill. And that the mutual fund industry sort of hopes that you forget about the after tax performance, and concentrate on pre-tax.

BRAND: So, what is a poor-end user supposed to do?

Mr. BLODGET: Look at your whole financial life from an after tax perspective. And certainly take into account, when you make investments, what the after tax performance is likely to look at. And you can get a sense of that from the turnover. And also, from looking at the after tax performance, which the mutual fund is required to disclose in the prospectus, if not in other marketing materials.

BRAND: And, Henry, can you give us one example of a fund that has a lot of turnover, versus a pretty stable one; what that would look like in terms of taxes?

Mr. BLODGET: Well, let's say that two funds have a 10 percent return on a year. If one fund has arrived at that return by trading its portfolio very actively, so that all of that gain has come from short-term gains, which are gains that are less than a year. Versus the other fund, which has simply made no trades all year long, and its stocks have gone up 10 percent, it's going to be a very different tax effect. On the first fund, you're going to have to pay short-term capital gains taxes, which are income taxes. So if you're in a very high tax bracket, that could be, including state and local, 50 percent. If you're just paying the long-term gain, that could be as low as 20 percent. So, you would arrive at a very different after tax return for both funds, even though they had the same pre-tax return.

BRAND: So, the big Achilles heel is short-term. You don't want short-term.

Mr. BLODGET: You really want to avoid short-term gains, unless you also have short-term losses that you can offset them against.

BRAND: Opinion and analysis from Henry Blodget. He writes the Wall Street Self-Defense column for the online magazine Slate. And you'll find his article on mutual fund taxes at slate.com.

Thanks, Henry.

Mr. BLODGET: Thank you, very much. Transcript provided by NPR, Copyright NPR.

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