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Mutual Funds: Avoiding Tax Surprises

Avoid Tax Surprises From Mutual Fund Distributions

Mutual funds are one of America’s favorite investment vehicles. According to the 2015 Investment Company Fact Book, nearly half of all U.S. households own mutual funds.1 Much of this popularity is due to the diversification benefits mutual funds can provide by offering exposure to multiple stock or bond investments in a single fund.

Another characteristic that makes mutual funds attractive is the way they distribute income. Funds are required to pay out the majority of their capital gains and dividends to shareholders each year, which is an appealing feature for investors looking to generate income. For investors focused more on saving, however, these distributions could result in surprise tax bills in two situations:

Holding mutual funds in a taxable account. If you hold mutual funds in a taxable account, the fund’s annual distribution could result in a significant tax bill come April, even if dividends are reinvested automatically. If you’re investing in a mutual fund that has a history of making large annual distributions, it may make sense to hold the fund in a tax-advantaged account like a 401(k) or an IRA, where the funds can grow tax-free until you’re ready to make withdrawals in retirement.

Buying mutual funds just before the year-end distribution. If you purchase the fund at the end of the year and the fund issues a year-end distribution, you could be subject to capital gains on the distribution without having actually earned any gains on the fund.

For example, let’s say you purchase a fund at the end of the year for $50 per share. The next day, the fund distributes $5 per share, which reduces the net asset value (NAV) to $45 per share. You reinvest the distribution, which brings the total value of your investment back to $50 per share ($45 NAV + $5 distribution). However, you still owe capital gains taxes on the $5 distribution, despite really just breaking even.

The lesson here is not to avoid mutual funds, but rather to understand how they’re taxed and what you can do to avoid unnecessary tax bills. In many cases, knowing when to purchase the fund and in which account to hold it can make all the difference.

1 Investment Company Institute, 2015 Investment Company Fact Book, 55th edition.

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Important Disclosures

Investors should carefully consider information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by visiting Schwab.com or calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Tax laws are subject to change, either prospectively or retroactively. Individuals should contact their own professional tax advisors or other professionals to help answer questions about specific situations or needs prior to taking any action based upon this information.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

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