High-income investors may be unaware that their brokerage accounts could be incurring substantial tax costs due to mutual funds. These investment vehicles, while traditionally seen as a solid option for diversification, can lead to unexpected tax bills that significantly diminish returns. This issue arises not from the performance of the investments themselves, but from the structural characteristics of mutual funds.
When investors buy into a mutual fund, their money is pooled with that of numerous other shareholders. The fund manager actively manages this pooled capital by buying and selling stocks or bonds. Under federal law, any realized gains from these transactions must be distributed to shareholders annually. This creates a situation where investors face tax liabilities they cannot control.
The key issues contributing to this tax burden include a lack of control over the timing of gains and the phenomenon of “phantom” gains. Fund managers make decisions based on overall portfolio strategy and investor redemptions, which means that individual tax situations are often overlooked. Consequently, investors may find themselves liable for taxes on gains even if they did not sell any shares.
The impact of these dynamics was starkly illustrated in 2022, when the S&P 500 index dropped nearly 20%. Many investors observed their portfolios declining in value while still receiving capital-gain distributions. For instance, the Growth Fund of America (AGTHX) suffered a loss of approximately 25% in 2022 but still issued a distribution of $3.71 per share in long-term capital gains in December. This dual setback of a depreciating portfolio alongside a tax bill for gains resulted in a challenging scenario for many investors.
Understanding the Costs Involved
Investors must also contend with additional hidden costs associated with mutual funds. For example, Class A shares often have a front-end load of up to 5.75%, meaning a $100,000 investment could lose $5,750 before any market exposure. In December 2024, the same fund distributed $1.15 per share in dividends and $6.38 in long-term capital gains. For a high-income taxpayer, this could translate to roughly $1,900 in federal taxes, as outlined in IRS Publication 550 and Topic No. 559.
In addition, the fund’s annual expense ratio, which averages 0.61%, equates to about $610 on a $100,000 investment. When combining these figures, the total first-year financial burden could leave a high-income investor starting at an effective disadvantage of 8.25%.
Exploring Alternative Investment Strategies
Fortunately, high-income investors have options that can help mitigate these tax implications. More effective investment tools exist that can enhance after-tax returns and reduce tax drag.
One such alternative is the use of exchange-traded funds (ETFs). Unlike mutual funds, ETFs generally avoid distributing capital gains due to their in-kind redemption mechanism, allowing managers to swap appreciated securities without triggering taxable events. This, paired with typically lower expense ratios, often makes ETFs a better choice for taxable accounts.
Separately managed accounts (SMAs) offer another viable option. These accounts provide investors with direct ownership of the underlying securities, allowing for individualized tax-loss harvesting that can offset gains in other areas of their portfolios. This flexibility can be especially beneficial for investors with more complex tax situations.
Direct indexing further enhances tax efficiency. Instead of investing in a single fund, investors directly hold the actual stocks of an index. This strategy enables advisers or managers to harvest losses from specific positions while maintaining overall exposure aligned with market benchmarks. Such granular control can substantially reduce taxable income over time.
Tax efficiency extends beyond the choice of investment vehicles; it also involves the locations of these investments. Growth-oriented or high-turnover funds should ideally be held in tax-advantaged accounts, such as IRAs or 401(k)s, while taxable brokerage accounts should focus on low-turnover, tax-efficient investments. This strategy, known as asset location, can significantly improve after-tax returns, potentially adding 0.5% to 1% per year—a compounding advantage over decades.
Ultimately, for high-income investors, the presence of actively managed mutual funds in taxable accounts may result in unnecessary tax liabilities. By shifting towards ETFs, SMAs, and direct indexing, investors can regain control over their tax exposure while enhancing overall efficiency. A portfolio represents more than merely a collection of investments; it is a comprehensive financial ecosystem that requires thoughtful management across various account types. By being deliberate about investment structures and locations, investors can address the silent erosion of their wealth and keep more of their earnings working for their future.
Josh Taffer is a Founding Partner and Wealth Advisor of Journey Wealth Strategies and serves as an investment adviser representative of Signal Advisors Wealth, LLC, a Registered Investment Adviser with the U.S. Securities and Exchange Commission.
Investors are encouraged to consult with professional advisers before implementing any strategies discussed, as this article provides general educational information and does not constitute personalized investment advice.
