How are mutual fund returns taxed?

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LazyNihilist
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How are mutual fund returns taxed?

Post by LazyNihilist » Sat Aug 01, 2020 11:54 am

Bogleheads,

I have a lot of questions about Mutual Fund taxation.

Vanguard reports 3 different returns on their fund pages.
Returns before taxes
Returns after taxes on distributions
Returns after taxes on distributions and sales of fund shares

Is Vanguard paying these taxes?
Does a fund pay taxes for dividends and cap-gains like an individual investor does for trading individual securities? Or is it left to the investor to pay the taxes?

For the returns listed by Vanguard, is it estimating the taxes that investors pay?
If everyone held a fund only in their Roth accounts, then theoretically all 3 returns should be the same right?

Is it the same for ETFs as well?
The strong do what they can and the weak suffer what they must -Thucydides

alex_686
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Re: How are mutual fund returns taxed?

Post by alex_686 » Sat Aug 01, 2020 12:01 pm

Not sure about Vanguard, but typically returns after taxes are estimated/simulated returns for a hypothetical average person. Your situation will be different.

Funds are pass through entities and pay little taxes. Mostly the tax liability gets passed through to the owners.

US tax code tries to make taxes equivalent if you own the asset directly or indirectly.
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dodecahedron
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Re: How are mutual fund returns taxed?

Post by dodecahedron » Sat Aug 01, 2020 12:05 pm

alex_686 wrote:
Sat Aug 01, 2020 12:01 pm
Not sure about Vanguard, but typically returns after taxes are estimated/simulated returns for a hypothetical average person. Your situation will be different.
Not the hypothetical ¨average" person, but rather folks in the highest tax bracket.

Edited to add: it is supposed to represent a kind of ¨worst-case¨ scenario of after-tax returns, but it actually fails to do that. Many folks in lower tax brackets are subject to a variety of indirect tax effects (e.g., phaseouts of credits due to higher AGI, taxable SS, etc.) that can make their effective marginal tax rate higher than even the highest bracket rate.
Last edited by dodecahedron on Sat Aug 01, 2020 12:07 pm, edited 1 time in total.

02nz
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Re: How are mutual fund returns taxed?

Post by 02nz » Sat Aug 01, 2020 12:05 pm

The after-tax returns are based on certain assumptions that probably don't fit you exactly. Generally the brokerage will NOT withhold taxes, and the fund doesn't pay them either; you need to figure them as part of your tax returns, using the 1099 form you get from the brokerage around February.

Mutual funds have capital gains and dividend distributions that are taxable if held in a taxable account. That means you'll owe some taxes even if you don't sell shares. This is what we call "tax drag." Generally index funds have much less of this. And ETFs generally only have dividend, not CG, distributions, and so they are the most tax-efficient of all. Vanguard index mutual funds with an ETF equivalent (like the Total Stock Market fund, VTSAX) are similarly tax-efficient because of Vanguard's patented share class structures.

And in a tax-advantaged account (traditional or Roth 401k/IRA or the like) all of this is a non-issue.

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Re: How are mutual fund returns taxed?

Post by livesoft » Sat Aug 01, 2020 12:10 pm

They are taxed like explained in this IRS Publication: https://www.irs.gov/pub/irs-pdf/p550.pdf
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Re: How are mutual fund returns taxed?

Post by retiredjg » Sat Aug 01, 2020 12:19 pm

LazyNihilist wrote:
Sat Aug 01, 2020 11:54 am
Bogleheads,

I have a lot of questions about Mutual Fund taxation.

Vanguard reports 3 different returns on their fund pages.
Returns before taxes
Returns after taxes on distributions
Returns after taxes on distributions and sales of fund shares


Here's how I understand it. Not sure it is all correct. Perhaps people can comment on things I might have wrong.

Returns before taxes are just that - what the fund returns before you pay taxes on it.

Returns after taxes on distributions - refers to how much is left of the return after you pay taxes on the annual capital gains distribution and dividends. You do not have to sell any shares for this - you are taxed even if you do not sell shares. I think this is calculated for the highest tax bracket.

If you subtract the second one from the first one, you get the "tax cost ratio" of that fund for the year in question. Tax efficient funds have low numbers like .45%. If that number is high, the fund is not tax efficient.

Returns after taxes on distributions and sales of fund shares refers to how much of the return is left after you sell some shares and pay all your taxes on it. I don't use this number and am not sure what else it might reflect.

All those numbers above only apply to a taxable account.
Is Vanguard paying these taxes?
No. This is an estimate of the taxes of a person in the highest tax bracket.

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Re: How are mutual fund returns taxed?

Post by grabiner » Sat Aug 01, 2020 12:40 pm

The tax numbers assume the highest federal tax bracket, but no state tax, and I believe only the income tax and not the Medicare surtax.

Therefore, the returns after taxes on distributions represent a reduction of 20% on qualified dividends and capital gain distributions, and 37% on non-qualified dividends, assuming that the remainder of the distribution is reinvested in the fund. For example, a fund with a 2% qualified dividend yield and an 8% annual return will return 7.6% after tax by this formula; you will pay 0.4% of the 2% yield and reinvest the other 1.6% so that you get a 7,6% annual growth rate.

The returns after taxes on distributions and sales of fund shares represent a reduction of another 20% on the unrealized capital gains. This tax is paid only once, and is annualized; if you lose 9.5% of the fund value to capital gains over 10 years, that reduces the annualized return by 1% (since a 1% loss compounded over 10 years is 9.5%).
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Re: How are mutual fund returns taxed?

Post by DSInvestor » Sat Aug 01, 2020 1:12 pm

FAIRMARK.COM has a section on Mutual Fund Taxation that I found to be quite useful:
https://fairmark.com/investment-taxatio ... tax-guide/

The information would apply for Mutual funds held outside of tax advantaged accounts so for what we would call Taxable Accounts here at Bogleheads.

Different rules apply for tax advantaged accounts like IRA, 401k, 403b, 457b etc. For these tax advantaged accounts, the mutual funds operate the same way internally but any dividend distributions or capital gains distributions received in these accounts are sheltered from taxation. The taxation event is when money is withdrawn from the account.
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Re: How are mutual fund returns taxed?

Post by livesoft » Sat Aug 01, 2020 1:18 pm

Vanguard.com explains the after-tax return right there on its web site. Click on the "Learn more about after-tax returns"
https://investor.vanguard.com/investing ... ax-returns

I'm surprised at some of the guesses made in this thread. :)
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LazyNihilist
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Re: How are mutual fund returns taxed?

Post by LazyNihilist » Sat Aug 01, 2020 1:43 pm

Thank you all for the replies.
The strong do what they can and the weak suffer what they must -Thucydides

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Re: How are mutual fund returns taxed?

Post by grabiner » Sat Aug 01, 2020 3:09 pm

livesoft wrote:
Sat Aug 01, 2020 1:18 pm
Vanguard.com explains the after-tax return right there on its web site. Click on the "Learn more about after-tax returns"
https://investor.vanguard.com/investing ... ax-returns

I'm surprised at some of the guesses made in this thread. :)
But this doesn't answer two relevant questions: does Vanguard include the Net Investment Income Tax, and does it include the foreign tax credit? A quick check of fund returns suggests that it includes both.
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Re: How are mutual fund returns taxed?

Post by livesoft » Sat Aug 01, 2020 3:35 pm

grabiner wrote:
Sat Aug 01, 2020 3:09 pm
But this doesn't answer two relevant questions: does Vanguard include the Net Investment Income Tax, and does it include the foreign tax credit? A quick check of fund returns suggests that it includes both.
In that case, then Vanguard should update the text on their web site to explicitly clarify all that, so that there would be absolutely no doubt about what they were doing.
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