Investing in a taxable account using mutual funds is particularly tricky at the end of the year. An investor should evaluate the performance and expenses of any fund under consideration as well as potential tax liabilities.
One advantage of investing in individual stocks is the ability to control capital gains. Capital gains are not taxable until the stock position is sold. The decision to sell is entirely up to the shareholder. However, realizing capital gains from a mutual fund is not always within your control. The shareholder pays tax on capital gains not only when shares are sold, but also if the mutual fund declares capital gains. The capital gains reported by the fund are based on the sale of positions held within the fund. Tax law requires the fund to pass on those gains to its shareholders.
Understanding Key Tax Components
There are two pieces of tax information you need to consider when evaluating a fund:
Realized Gains
These are gains realized internally by the fund but not yet distributed. An investor who buys shares of the fund before gains are distributed could pay tax on gains they didn’t earn. Check the fund’s website to see if gains have been declared and when they plan to distribute them. Waiting until the fund goes ex-dividend to buy shares in a taxable account can avoid a taxable distribution. A second option is to buy the fund in a retirement account. Capital gain distributions are not taxable in these types of accounts.
Unrealized Capital Gains
These represent the fund’s appreciation that has not yet been realized. These gains could become taxable if the fund sells some of its appreciated positions before year-end. There is really no way to know whether this will happen. Passively managed funds (such as index funds) are less likely to realize gains unless there is a run of massive redemptions, which would force the fund to liquidate stocks to pay out distributions.
Preparing for Potential Distributions
There are several precautions investors should take to avoid the unpleasant surprise of a mutual fund capital gain distribution. Start by doing some homework. Most funds begin forecasting distributions in October. Email the fund for information if you can’t find anything posted on their website.
Morningstar includes information on unrealized gains for the funds it follows. The information is listed as a percentage under the potential capital gains exposure section. Investors may want to stick with exchange-traded funds (ETFs) and index funds that are relatively tax-efficient when choosing investments for taxable accounts. In addition, consider investing in actively managed funds that may be less tax-efficient in retirement accounts. Turnover is also an important indicator of a fund’s tax efficiency. Funds with high turnover should be held primarily in retirement accounts.
How Distributions Are Taxed
When funds report distributions, they classify them as long-term capital gains, short-term capital gains, or regular dividends. The shareholder reports the long-term capital gain on Schedule D of their tax return and the rest as either qualified or non-qualified dividends.
The long-term capital gain is treated as if the investor personally entered the transaction that produced the capital gain. A taxpayer could use realized losses from other trades to offset the mutual fund gain. The tax rate on the capital gain distribution depends on the taxpayer’s bracket.
Capital Gains Rates for the 2026 Tax Year
| FILING STATUS | 0% RATE | 15% RATE | 20% RATE |
| Single | Up to $49,450 | $49,451 – $545,500 | Over $545,500 |
| Married filing jointly | Up to $98,900 | $98,901 – $613,700 | Over $613,700 |
| Head of household | Up to $66,200 | $66,201 – $579,600 | Over $579,600 |
Source: IRS.gov
Higher rates apply to certain categories of long-term capital gains, such as the sale of gold. The IRS categorizes gold and other precious metals as “collectibles,” which can be taxed at up to the 28% long-term capital gains rate. Investors who own shares of mutual funds that hold these investments may have taxable capital gains distributions subject to the collectibles tax rate.
Taxpayers with higher incomes could also be subject to the Net Investment Income Tax (NIIT) on capital gain distributions. This additional tax is 3.8% on the lesser of net investment income or modified adjusted gross income (MAGI) over $250,000 for married taxpayers filing jointly and $200,000 for single taxpayers.
Final Considerations
Investing in mutual funds for a taxable account towards the end of the year requires a few extra steps. However, extra care could save needless taxes on April 15.
Key Insights
- Taxpayers should exercise care when buying funds at the end of the year to avoid paying tax on gains earned by the fund.
- Fund research should include information on realized and unrealized gains within the fund.
- The turnover rate of a fund is a good indicator of its tax efficiency going forward.
