There are two times you may pay capital gains tax when you own a mutual fund:
- Capital Gains Tax In A Mutual Fund
When you sell shares of the fund, if you sell them for more than you paid for them, you will realize either a short term or long term capital gain.
- Embedded Gains In A Mutual Fund
Inside of the mutual fund, if the fund sells stocks or bonds that have a gain, that gain must be passed along to you as a shareholder of the fund, so the fund will distribute the gain. Even if you choose to have these types of capital gains reinvested, you will still receive a 1099 which shows the amount of the gain, and you will have to report the gain on your tax return and pay the applicable amount of tax. These types of internal capital gains are usually distributed near the end of the year.
This second type of gain is often called an embedded capital gain, because even if you have only owned the fund for a short while, you could end up receiving a capital gain distribution, and having to pay tax. The gain could be from a stock the fund purchased long, long ago, yet you will still have to pay the tax.
Tax Managed Funds Reduce Embedded Gain Distributions
A tax managed mutual fund is managed to minimize this type of embedded capital gain distribution.
Tax managed funds also attempt to reduce other forms of taxable distributions such as interest and dividend income. For example, a tax managed balanced fund, which owns stocks and bonds, will often own municipal bonds, which generate interest that is free of federal income taxes.
Tax managed funds are an appropriate investment option for non-retirement accounts.
