Do we get the "deferred tax" property like an IRA or 401(k), when we buy a mutual fund?

Question

Although mutual funds (in USA) tend to move their position very slowly, but after 10 years or 20 years, that'd be more.

For example, if we buy a mutual fund in year 2000, and they invested in Microsoft and Oracle, and then they sold them at a gain in year 2003, are those gain subject to immediate tax? Because if the capital gain is not subject to immediate tax, doesn't the mutual tax have similar effect of an IRA or 401(k), for the "deferred tax" property?

So for example, if we buy into the fund at $50 and we sell it at $150 after 20 years, is that all "tax deferred" during that 20 years?

Answer 1

If you own shares in a mutual fund in a taxable account, then whenever the mutual fund does a quarterly or annual distribution of dividends, interest, or capital gains you will receive a 1099 at the end of the year. You will then include that 1099 numbers in your income tax calculations. Depending on your income situation, and the nature of those distributions, you may owe taxes. It can be nothing if the numbers are small enough, or a lot depending on your situation. This happens even if you don't sell any shares during the year. It doesn't depend on if you reinvest the distributions, though if you do then the number of shares will grow over time.

Now if you owned the shares in a retirement account such as a traditional IRA or pre-tax 401(K), then the taxes are deferred until you start removing money from the retirement account. These dividends, interest, and capitals gains will be mentioned in the quarterly/yearly statements, but they don't have any tax impact until much later.

If the shares are owned in a Roth IRA or Roth 401(k) then the dividends, interest, and taxable gains distributed will never have a tax impact.

In a comment to another answer you said:

"I just talked to the mutual department of an brokerage house. The representative first said we do not have to pay tax on the dividend or the capital gain of the mutual fund. And then he said it depends. And then I ask him, say, if it is this FSELX fund, then do we pay tax. And then he says need to consult a tax professional (this is the standard answers every where)..."

The answer is it depends. The shares in the mutual fund can be owned in:

• Taxable account
• Traditional IRA
• Roth IRA
• Pre-tax 401(k)
• Post-tax 401(k)
• Roth 401(k)
• 529 account
• HSA

It can even be owned by another Mutual Fund or ETF which could also be owned by in one of those account types.

Answer 2

When a mutual fund sells one of its holdings for a capital gain, the total amount of cash received the mutual fund from the sale by the holding "remains" in the fund and is usually re-invested into other holdings, stocks or bonds (or both) as the case may be, as per the prospectus of the fund. There may be other sales during the year of mutual fund holdings, not necessarily for a gain each time. However, usually once a year, typically in December, the mutual fund pays out the net capital gains (sum of all capital gains - sum of all capital losses) to the investor which the investor can choose to reinvest in the mutual fund (thereby gaining additional shares in the fund) or receive in cash. The investor usually makes the choice when opening the mutual fund account, and if none is made, the default option is to reinvest all capital gains (and dividends). However, this choice can be changed at any time by contacting the fund. Note that if the sum total of all capital losses exceed the sum total of all capital gains, for a net capital loss, the loss is retained in the fund (the fund won't demand more money from the investor to make up the loss!) and used to offset capital gains in future years (for up to eight years). However, regardless of whether the capital gains (or dividends) are received as cash, or reinvested in mutual fund and so the investor receives "no cash in hand", these amounts are taxable to the investor as capital gains (or dividends) in the year that they are distributed. The mutual find will issue a Form 1099-DIV listing all these amounts (with copy to IRS) and if these amounts are not properly listed on the investor's tax return (the investor's copy of Form 1099-DIV does not need to attached to the tax return), the IRS will come back with a query or audit.

Finally, turning to the last question asked by the OP

So for example, if we buy into the fund at $50 and we sell it at $150 after 20 years, is that all "tax deferred" during that 20 years?

if all dividend and capital gains distributions over the twenty years were received as cash and not reinvested fund, then the capital gain is not "tax-deferred" in the sense that one doesn't owe capital gains tax on unrealized gains; the capital gain occurs as of the date when the investor redeems the shares by returning them to the mutual fund company and requests cash (or re-investment into another mutual fund run by the same investment house or mutual fund company). It is worth keeping in mind that, typically, income tax is not withheld from the sale, and so there can be tax consequences such as interest and penalties for underpayment of estimated taxes unless quarterly estimated taxes are filed using IRS Form 1040-ES (and similarly for state income tax) or tax withholding from wages etc is increased to cover the tax on the capital gains.

Answer 3

Regular mutual funds are required to distribute capital gains/income to shareholders when they sell holdings.

So in your example in 2003, you as a shareholder of XYZ mutual fund would get a capital gain distribution entry on your 1099-DIV for the 2003 tax year. Mutual funds also adjust distributions for capital losses so in a down year there may not be any.

The reason why 401k/IRA are considered "tax advantaged" is that the US shareholder using those types of accounts doesn't need to pay the tax on such capital gains/income distributions allowing for compound growth opportunities.

The capital gain distribution from a mutual fund is different than the capital gain of the mutual fund that you bought at a $50 NAV value and sold at a $150 NAV value.

See: Capital Gains and Capital Gain Distributions for a mutual fund

Additional: https://www.investopedia.com/articles/investing/060215/how-mutual-funds-are-taxed-us.asp