Shares of mutual funds represent ownership of an underlying pool of stocks, bonds or other securities. A mutual fund company issues shares to and redeems (or repurchases) shares from investors. To withdraw money from a mutual fund, you start by selling shares, which might trigger capital gains taxes and possibly sales charges.
Back-End Sales Charges Can Sting
No-load mutual funds have no sales charges, but many funds charge front-end fees, back-end fees or both. Front-end charges occur at the time of share purchase, whereas back-end charges are triggered by sales. Sales charges can be as high as 8.5 percent by law, though most range from 3 to 6 percent. Sales charges are collected by brokers who help market the mutual fund shares. Some mutual funds offer back-end fees that decline over time, encouraging investors to hold shares for the long term.
Sales Create Tax Events
Selling mutual fund shares triggers a tax-event that you would have avoided if you hadn’t sold the shares. The tax event is based on the profit or loss resulting from the share sale. A profit is measured as the excess of the sale proceeds minus the purchase cost, after adjusting for commissions and fees. Profits are taxed at capital gains rates.
Capital Gains Require Separate Treatment
Capital gains result from the profitable sale of property, including financial securities such as mutual fund shares. Long-term capital gains are profits from the sale of property held for more than one year, and are taxed at a favorable rate. The three long-term capital gain rates are 0, 15 and 20 percent as of 2018, depending upon your total taxable income. Short-term capital gains, for shares held for a year or less, are taxed at the same rates as ordinary income. Those rates as of 2018 are divided into seven brackets from 10 to 37 percent. You must separate capital gains from ordinary income on your tax return.
IRA Mutual Fund Penalties
If your IRA is invested in one or more mutual funds, withdrawing money from the IRA can not only trigger back-end sales charges, but also taxes and an early-withdrawal penalty. Withdrawals from a traditional IRA are always taxed as ordinary income, never as capital gains. Furthermore, if you are younger than 59 ½, you might be assessed a 10 percent early withdrawal penalty unless you qualify for an exception. In the worst-case scenario, you might be hit by an 8.5 percent back-end charge, a 10 percent penalty and a 37 percent tax bill. In other words, you might keep less than half of the gross sale amount.