Mutual funds provide an easy way for an investor to achieve instant diversification across multiple securities with a single transaction. This is valuable because most investors can't afford to efficiently diversify so widely. However, there are downsides to mutual fund investing. High-net-worth investor may want to consider using a private money manager to handle a separately managed account, for greater tax efficiency and greater after-tax returns.
Mutual funds can be held either outside of retirement accounts, in taxable accounts, or within individual retirement accounts (IRAs) and similar savings vehicles. Assets in IRAs and 401(k)s do not incur any kind of tax during the growth phase - either on dividends or on capital gains. They do, however, get taxed as ordinary income when assets are withdrawn. Roth IRAs are tax free, provided the assets have remained in the account at least five years. They are funded with after-tax dollars. One of the key disadvantages of using IRA and 401(k)-type investments is that the investor forgoes the advantageous long-term capital gain treatment on investment assets, which is much lower than ordinary income taxes.
Dividends from mutual funds held in ordinary accounts, as opposed to IRAs, 401(k)s and similar arrangements, are taxed at qualified dividend rates. Other company dividends get taxed as ordinary income. Interest payments from bonds held in mutual funds get taxed as ordinary income, except for municipal bond funds, which are generally tax free. The government levies capital gains tax on any net profits of shares sold, as well as any distributed capital gains from a mutual fund's portfolio. The government taxes shareholders on the capital gains within the mutual fund portfolio, even if the shareholder doesn't sell any shares. The shareholder could be liable for the tax, if they hold shares as of the date the fund distributes gains, even if they did not participate in the gains.
Separately Managed Accounts
With managed accounts, a money manager buys and sells securities on behalf of an individual investor. The investor's funds are not pooled with anyone else -- unless the money manager buys funds or annuity products on the investor's behalf. This allows the investor to retain control over when he realizes capital gains. For example, there is no risk of getting stuck with a taxable capital-gains distribution on a fund he only held a few days. The fund manager tries to limit tax exposure of the portfolio. If he sells a security at a profit, he seeks to sell another security at a loss to offset any capital-gains tax, if possible.
Fees and Expenses
Mutual funds can charge a sales load, typically 6.2 percent of invested assets, although some funds, called no-load funds, have no sales charges. Mutual funds also charge a percentage of assets each year, called an expense ratio. Some funds also charge an additional fee, called a 12b-1 fee, to offset marketing expenses. Managed accounts typically charge a percentage of assets under management.
Leslie McClintock has been writing professionally since 2001. She has been published in "Wealth and Retirement Planner," "Senior Market Advisor," "The Annuity Selling Guide," and many other outlets. A licensed life and health insurance agent, McClintock holds a B.A. from the University of Southern California.