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Unrealized Capital Gains – An Overlooked Cost of Mutual Funds

I received my 1099-DIV today from Oakmark Funds and was unpleasantly surprised when I saw $1,013 of total capital gain distributions. I always look at management fees when considering a fund but haven’t really examined tax implications, probably because most of our investments are in 401k, 403b, or IRAs. I’ll have to start paying more attention to this in our taxable investments.

Tax Liability

I found a good explanation by Jason Fitchner of how investors incur capital gain distributions even without selling any shares of a fund.Ã¢â‚¬Â

“An individual owns 1,000 shares in Mutual Fund ABC, which were purchased for $10 per share (for a total cost of $10,000). The shares of the mutual fund represent ownership, or various rights to capital assets, in the mutual fund. In the course of the mutual fund’s normal buying and selling of securities, any assets that are sold by the mutual fund at a price in excess of that at which they were purchased creates a realized capital gain and a tax liability. If Mutual Fund ABC realizes capital gains of $1 per share, the individual investors are responsible for the tax liability even if they themselves haven’t “realized” or exchanged their shares for money. Even though the gains are reinvested, this is considered to be a realized gain to the mutual fund company. The tax liability is passed-through to the individual shareholders even though this is an unrealized gain to the shareholders of the mutual fund. Even if individual shareholders do nothing more than buy and hold mutual fund shares, they could still be hit with a potentially large tax liability due to the distribution of gains from their mutual funds. Shareholders are then forced to either sell assets to pay the tax liability, or divert funds from other sources. This creates an opportunity cost to the shareholder and can result in lost economic gain due to compounding.”

Appreciation vs. Taxes

Taxable distributions can cut into your overall earnings. Even though my investment in the fund appreciated around $1,500 in 2006, I have total capital gain distributions of $1,013. I won’t necessarily realize the gains from this appreciation because the fund’s value could go down again before I sell. However, I definitely have at pay the taxes.