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I am very new to investing and I have learned that owning a mutual fund with a high turn over coefficient may result in capital gains which are taxable.

This concerns the US only.

My question, however is about the mechanism how it is taxed.

Let's say I invest $10K in a mutual fund with a high turn over ratio. During one year the fund manager sold many stocks high and bought many other cheap. My fund is doing well and my money is growing. I am not planning to sell my stake for a few years.

Do I need to come up with cash to pay taxes on capital gains after one year even if I did not redeem my holdings in this particular mutual fund or do I need to worry about taxes only when cash out ?

Thank you in advance.

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In the US, funds are not taxed on their realized gains, instead the shareholders are taxed. Funds realize gains when they need to sell holdings at gain (after deducting losses) for whatever reason (rebalancing, excessive withdrawal rate, change of investment policy, etc).

Your portion of the gains will be reported on the 1099-DIV you'll get from your broker or the fund, if you're a direct investor. Note that even though you might not get an actual distribution, it will be reported as if gains have been distributed to you. In that case (you didn't get a distribution, but the fund reported capital gains) your basis will be reduced accordingly. Some brokers do the math for you, but if you're holding the fund for a while (since before 2013) - most won't. You'll have to keep that in mind when you sell and adjust cost basis accordingly.

So the bottom line is that the capital gains reported to you on 1099-DIV will go to the 1040 of the year for which they've been reported, as either long or short capital gains (or both...) as reported, and you'll pay tax on them. When you sell the holding, you'll pay the tax on the gain you have realized (and not the fund).


As for the retirement accounts (IRA, 401k, etc) - they're better vehicles for these kinds of funds because capital gains are not taxed. Neither are dividends or any other earnings and distributions from holdings into the account. So the capital gains passed to you get cancelled out by the preferential treatment of the account. You will not receive 1099-DIV or 1099-B for these accounts, only 1099-R for distributions, which may be taxed as ordinary income or not taxed at all (qualified Roth distributions).

So while you'd think twice whether to get into an actively managed fund in a regular brokerage account, this (quite significant, occasionally) disadvantage disappears when you're investing in a tax-sheltered account.

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