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You need to know 11 things

This simple guidebook is aimed at investors with mutual funds and ETFs in their taxable accounts. None of it applies to tax-sheltered accounts like IRAs.

1. Funds are pass-throughs. If they profit from capital gains, interest or dividends, they are compelled to pass those profits through to you as distributions. You must pay tax on the distributions. You owe the same tax whether you do or don’t reinvest in more fund shares.

If the fund has long-term gains (profits on securities held for more than a year), they get passed through as long-term gains taxable at low rates. If the dividends collected by the fund are “qualified” (eligible for the favorable rate), then they get passed through to you as qualified dividends. If the fund collects interest from tax-exempt municipal bonds, then your income distribution is treated like tax-exempt interest.

Note: Income distributions from bond funds appear on your tax return as “dividends.” But they get taxed as if they were interest.

2. The distributions go down a one-way street. Gains and net income are distributed. Losses are not distributed.

If the fund has a net loss from its trading, this can’t be passed through to you for you to use on your tax return. The fund just sits on it, carrying the loss forward to later years when it can be used to offset a gain.

3. The distributions cause pain to innocent victims. You owe tax on a distribution even if you didn’t benefit from it.

Say a fund starts out worth $10 a share, and doubles in value as its stocks climb. You buy in at $20. Soon after, the fund distributes $5 a share of realized gains. When that happens, you have $5 of cash plus a fund share now worth only $15. You become an innocent victim. You have to pay tax on the $5, even though at this point you are just breaking even.

There’s an antidote in this situation. Sell the fund share for $15. Your $5 loss on the fund share offsets the $5 capital gain. Your net gain is $0, so there’s no tax to pay.

All of this buying and selling is a nuisance. Instead of curing the problem, prevent it by not buying funds that are about to make distributions. The big ones often come at the end of the year. If you are looking at a fund that has been performing well and does a lot of trading, avoid buying it late in the year. Wait until January.

4. Reinvesting is a bad idea. You put $100,000 in a fund, it makes a $5,000 distribution, and you use that to buy more fund shares. That sounds nice, except that it messes up your cost basis. You now have two lots of shares with two purchase prices and two holding periods. Keep this up for a decade and you could wind up with 10 or 40 or even 120 purchases. Now what happens when you want to take some money out? That means selling shares. Which shares are you selling? Bought at what prices?

The only way to cope with this mess is to use the fund company’s “average cost” calculation when you sell shares. That’s suboptimal. It would be better to identify the high-cost shares as the ones you’re selling.

A better idea is to check “No” when asked about whether to reinvest. Send distributions (both income and capital gain distributions) into your money market account. When that account gets fat, use it to make a lump-sum purchase of the same or a different fund. When you want to need to raise cash, you can pick a high-cost position to minimize your tax burden.

5. Stock index funds cause little tax pain. These are funds that buy a fixed collection of stocks, such as all the ones in the S&P 500 index, and sit on them. Since they don’t trade in and out, they don’t realize very many gains. So there’s not much except the dividend income that has to be thrown out on the fund investors.

An index fund does occasionally have to sell, such as when it gets a lot of redemption orders. But if it selectively sells the high-cost share lots first, it may wind up with no capital gain.