How does taxation work on non-retirement investment accounts when selling and subsequently buying?

Question

I'd like to invest in a non-retirement investment account - I'm looking at the Vanguard 500 Index Fund Admiral Shares product specifically.

However I don't know how gains work, exactly - my understanding is that when I buy into this fund, I become the owner of a share of the fund (similar to a share in a publicly traded company?) and as the fund changes in value so do my shares in the fund: if the fund increases in value then my own net worth (non-liquid) also increases; however because a share of the fund is not considered actual currency it means I'm not taxed when the fund increases in value (as I would be with bank interest paid to me); it is only when I cash-out my shares back into USD (if I make a profit) do I pay tax on the capital-gain.

I understand funds themselves are responsible for investing in companies - but what happens when the fund chooses to de-invest in a company and then invest in another? Obviously it sells its shares first (resulting in a "profit", hopefully) but how is that taxed? As it's a fund rather than a company is it making a taxable profit? If the money is immediately re-invested is that considered an expense and so no taxable event happened?

...if funds can do that, why can't I do that as an individual? I note that if I buy $250 worth of shares in Massivesoft Inc, then sell them for $1000 later I'm taxed on the $750 profit even if I immediately re-invest it in Banana Computer Inc and the $750 never touches my bank account. What happens if I "trade" one share for another (of equivalent USD value) and nothing is actually converted to currency?

Answer 1

In a taxable account you're going to owe taxes when you sell the shares for a gain. You're also going to owe taxes on any distributions you receive from the holdings in the account; these distributions can happen one or more times a year.

Vanguard has a writeup on mutual fund taxation.

Note: for a fund like you linked, you will owe taxes annually, regardless of whether you sell it. The underlying assets will pay dividends and those are distributed to you either in cash, or more beneficially as additional shares of the mutual fund (look into dividend reinvestment.)

Taking VFIAX's distributions as an example, if you bought 1 share of the fund on March 19, 2017, on March 20th you would have been given $1.005 that would be taxable. You'd owe taxes on that even if you didn't sell your share during the year.

Your last paragraph is based on a false premise. The mutual fund does report to you at the end of the year the short and long term capital gains, along with dividends on a 1099-DIV. You get to pay taxes on those transactions, that's why it's advantageous to hold low turnover mutual funds in taxable accounts.