This is a transcript of the conversation I had on MomsMakingaMillion radio. Each week we discuss a topic about investing. This time we turn our attention to the mainstay of our retirement plans, the mutual fund and what few of us consider: taxes.
Kat: We have been talking about 401(k)s for a couple of months now. But most of us don’t know what to invest in once we have them. So it would be great if we could talk about the mainstay of these accounts: the mutual fund.
Paul: I love mutual funds, always have, always will. The concept is simple enough to understand: You join a group of like minded investors, hire a fund manager and let him do the tough work of making you money.
Kat: Sounds so easy when you explain it like that. But it isn’t always that easy is it?
Paul: Unfortunately no. Even something as elegant and simple sounding as a mutual fund have all sorts of potholes and road hazards. Mutual funds do tend to level the investment playing field but not always.
And while mutual funds have always been a somewhat difficult concept to understand, it is what we have to work with. The vast majority of us who come into contact with these funds do so inside a 401(k). As we have talked about it over the previous shows, 401(k)s are nothing more than a line in the tax code. So I thought we would talk about taxes.
Kat: But if our listeners have a 401(k), which is tax-deferred, do taxes matter?
Paul: Yes and no. Yes because mutual funds can deliver tax consequences that eat away at your returns and no because if you pick the right fund, those tax events will have less of an impact on your return and that means more retirement dollars.
Kat: How do mutual funds create tax events?
Paul: Unfortunately, the same way you create them as an individual investor: by selling profitable holdings. Mutual fund managers look for great stocks and when they find one, they hold on to it. So utterly confused tip one when looking for a good mutual fund is to find a manager who trades infrequently.
This is expressed as portfolio turnover. If a fund manager buys and sells everything she or he owns in a given year, the turnover is 100%. The lower the turnover, the lower the trading costs and the lower the chances are you will have to pay taxes. The higher the turnover the more likely there will be some taxes to be paid and a greater chance of lower overall returns.
But sometimes, as was experienced at the end of 2008 and into 2009, mutual fund investors, just like everyone else panicked and sold their shares in the fund as their portfolios fell in value. When this happened, the fund manager had to give them cash and the only way they were going to get the cash was to sell something. If it was a profitable holding, it created a tax event.
Kat: But who paid the taxes?
Paul: Also unfortunately, it was the shareholders who didn’t sell. And sometimes the new shareholders who unwittingly bought into the fund just as the taxes were distributed. In a mutual fund, every thing is, well, mutual: the gains, the losses and the taxes.
An older gentleman once suggested that taxes were one way to know you made money. The question is: how do you avoid them? Our second utterly confused tip: only buy after a scheduled distribution. These generally take place at the end of a quarter or the end of the year. Buy in after that, and the taxes you pay are on the shares you own, not on something that happened before you even got there.
Kat: So we look for a fund with a low turnover and buy it after the scheduled distribution. Is there anything else we should look for?
Paul: The last utterly confused tip for mutual funds is finding a long-term manager. This is not as easy as it sounds especially if you are locked in a plan that has only a few funds or all the funds are from the same family. If that is the case, look for a fund with a good long-term consistent performance instead. This is one indication of stability in trading and as a result, less taxes to subtract from your return.
You may pay taxes on your gains when you retire and when you begin to take distributions, but we need to keep in mind that the fund pays taxes on its activities all along and deducts them from your returns.
Kat: How about we discuss the topic of performance next week?
Paul: That would be the perfect next step in picking the right fund.
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