Capital Gains Taxes Trap: How to Avoid Mutual Fund Tax Bombs
It’s bad enough when your mutual fund’s assets lose value, but owing unexpected capital gains taxes after those losses is doubly frustrating.


Many know that capital gains taxes are what you owe when you sell an investment that has gained value since you bought it. What’s less well-known is that you can end up owing capital gains taxes on an investment that has lost value since you purchased it and that you haven’t even sold!
Getting caught in that capital gains tax trap has led many to unpleasant and expensive surprises come tax season. There’s a way to avoid this problem, but only if you understand why it happens.
Mutual Funds: Popular Investments, With Pitfalls
Mutual funds are attractive because they provide automatic diversification. Rather than having to buy dozens of different assets in order to diversify your portfolio, you can buy into a mutual fund that already owns a wide variety of assets.

Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
But because of how they’re structured, there are some interesting caveats to consider. When another investor in a mutual fund decides to sell their stake, the mutual fund has to pay them the value of their shares. Because the mutual fund itself doesn’t usually maintain large amounts of cash assets, when it owes money, it must raise those funds by selling its assets.
If those assets are worth more when the mutual fund sells them than they were when it bought them, the fund will owe capital gains taxes that its remaining members must pay. Members with large stakes in a mutual fund that sells a lot of assets that have greatly appreciated in value can find themselves owing tens of thousands of dollars in capital gains taxes, even if the overall value of the mutual fund went down in that tax year!
You might think an easy way to save members from owing large tax bills at the end of the year would be for a mutual fund to structure its asset sales such that some are sold at a loss in order to offset the assets that gained in value via tax-loss harvesting. You’d be right! Balanced selling would be a good solution, but for many mutual funds, there’s an incentive not to do that.
Highly Focused on Performance Metrics
Mutual fund performance metrics are based on how much value the mutual fund’s assets gain. Selling only assets that have gained in value increases the mutual fund’s performance assessment. Investors looking for a mutual fund to buy into are understandably more likely to choose one that reports highly positive performance than one that reports middling or negative performance.
In order to attract new investors by showing the highest performance possible, mutual funds often make decisions that negatively impact their current investors’ tax picture. There are several ways to avoid this problem:
If your mutual fund is part of an employer-sponsored 401(k), you’ll automatically avoid it because those accounts have different tax regulations that, by default, shield them from capital gains when funds inside them sell assets.
If you wish to invest in a mutual fund outside of an employer-sponsored account, look for a “tax-efficient” mutual fund. These funds take into account the tax burden they’re imposing on their investors when making divestment decisions.
However, these funds still have the fundamental weakness of you not being in control of what they do. You are relying on the decisions of the fund managers to make your investment worthwhile. Fund managers will naturally make decisions that prioritize the survival of the mutual fund itself rather than focusing on the tax implications for their investors. If those decisions aren’t in your favor, your retirement savings can suffer.
Avoiding the Tax Bomb: ETFs
Another option, and one we often steer our clients toward, is to avoid the mutual fund altogether and instead consider an ETF. In the past, people invested in mutual funds for diversification, even with small investments. Being able to spend $1,000 to invest in 3,000 companies is attractive because of the automatic diversity of your investment.
Today, ETFs do the same thing, but you avoid the risk of stumbling into the capital gains trap. We much prefer to see our clients invest in individual securities and ETFs for their taxable retirement accounts. The investor can derive the same portfolio diversity as with a mutual fund while gaining the ability to direct their investments personally. We feel that, when possible, it’s good practice to be completely in control of your investments.
It's Important to Work With a Fiduciary
The mutual fund tax bomb is one that’s often encountered by people whose financial professionals lack an individualized approach to each client and who have been incentivized to sell certain products — it’s common to encounter investment firms that are motivated to sell certain products.
If a broker receives a commission every time a client invests in a mutual fund, there’s a natural tendency for that broker to want every client to invest in that mutual fund! That’s why it’s important to choose an independent fiduciary adviser who does not get paid based on which products their clients choose. Only with such independence can a client be confident that their interests are prioritized over their adviser’s profits.
Get Kiplinger Today newsletter — free
Profit and prosper with the best of Kiplinger's advice on investing, taxes, retirement, personal finance and much more. Delivered daily. Enter your email in the box and click Sign Me Up.

As Principal and Director of Financial Planning, Sam Gaeta helps clients identify financial goals and make plan recommendations using the five domains of financial planning — Cash Flow, Investments, Insurance, Taxes and Estate Planning. He is responsible for prioritizing clients' financial objectives and effectively implementing their investment plans and actively monitors the ever-changing nature of clients' financial and investment plans.
-
Should You Ditch Your Medicare Advantage Plan? Most People Do
If you want to switch your Medicare Advantage plan or enroll in original Medicare, you're not alone. Here's when it's a good idea and how to go about it.
-
The 401(k) Mistake That Could Cost You Millions in Retirement Savings
Thinking about reducing your 401(K) contributions in the current market? Here are six reasons why you may want to reconsider.
-
What the HECM? Combine It With a QLAC and See What Happens
Combining a reverse mortgage known as a HECM with a QLAC (qualifying longevity annuity contract) can provide longevity protection, tax savings and liquidity for unplanned expenses.
-
721 UPREIT DSTs: Real Estate Investing Expert Explores the Hidden Risks
Potential investors need to understand the crucial distinction between a REIT's option to buy a Delaware statutory trust's property and its obligation.
-
I'm an Insurance Expert: Yes, You Need Life Insurance Even if the Kids Are Grown and the House Is Paid Off
Life insurance isn't about you. It's about providing for loved ones and covering expenses after you're gone. Here are five key reasons to have it.
-
My Professional Advice: When It Comes to Money, You Do You
This is how embracing the 'letting others be' and 'learning to surrender' mindsets can improve your relationship with money.
-
Direct Indexing Expert Explains How It Can Be a Smarter Way to Invest
Direct indexing provides a more efficient approach to investing that can boost after-tax returns, but is it right for you?
-
Smiley Faces in Serious Places: Emoji Use Pops Up in Legal Battles Over Inheritances
Estate planning attorney notes how emojis are crossing over from casual conversation to litigation. What was once dismissed as 'just an emoji' is now carefully scrutinized.
-
When Downsizing, Does a Continuing Care Retirement Community Make Sense?
The idea that you'll never have to move again may sound tempting, but how about the costs? A financial planner explores the pros and cons of this style of retirement living.
-
Fortune Favors the Gold: Expert Highlights a Little-Known Game-Changing Investing Strategy
Rather than only owning gold bullion itself and investing in gold mining companies, consider adding gold royalty companies to your gold investing strategy.