So, it is essential for Investors to understand the difference between a tax-advantaged account and a taxable account, and how mutual funds could be effectively used within each of those account types.

Check out our mutual fund education section to know more about different ways to invest in mutual funds.

Typically, a standard “taxable” account is titled as an individual or joint account. The account owner has the ability to contribute or withdraw without any penalty. However, every time an investment transaction is done, it could be considered a taxable event and trigger a capital gains or dividend tax. For example, if an investor deposited $10,000 into a joint account, purchased a mutual fund and then sold that same fund when it grew to $15,000, the profit of $5,000 would be taxed. That $5,000 would be considered a capital gain and if it was held longer than a year, it would be taxed at more favorable long-term rates. However, if it was sold in less than one year from when it was bought, the capital gain is considered short-term and taxed at the account owner’s marginal tax rate. Now, if the fund was sold at a loss, or say $8,000 from the original $10,000 investment, there would be no tax paid. In this case, there is no profit but the account holder would have a realized loss of $2,000, which could then be used to offset future realized capital gains.

Along with capital gains, taxable accounts are also subject to dividend taxes. Just like any common stock, many mutual funds pay a distribution to their shareholders. Depending on the fund and its underlying investments, the distribution could be taxed at a qualified dividend rate or at an ordinary income rate. The qualified dividend rate is always the more favorable, as it has the same tax rate as a long-term capital gain, which would be typically lower than the marginal tax rate of the investor.

Check here to learn how capital gain distributions are taxed.

Tax-advantaged accounts are savings vehicles that the IRS gives favorable tax treatment since they are mostly geared toward retirement. The most common tax-advantaged account is the Individual Retirement Account or IRA for short. This is a type of retirement account that allows its holders a tax deduction on contributions and the ability to defer taxes until the withdrawals are made. Other common tax-advantaged accounts are 401(k)s, SEP IRAs, annuities and Roth IRAs.

What makes tax-advantaged accounts more beneficial when it comes to investing is that the account owner does not have to worry about the taxes during trading. The account owner can buy and sell as they please and not worry about taxes, regardless of the holding period. Dividends are also not taxed within the account and can be reinvested to boost the size of the additional tax-advantaged account.

As great as mutual funds can be for an investor’s portfolio, it can also cause unnecessary taxation if held in a non-tax advantaged account. This is one of the reasons why exchange-traded funds (ETFs) have been gaining popularity, due to their more tax-efficient manner.

Since mutual fund managers are actively trading the fund’s underlying holdings, taxable transactions are made throughout the course of the year and will eventually be passed on to its shareholders. Mutual funds typically make distributions toward the end of the calendar year, regardless of when the shareholder first began investing. For example, the Franklin Small Cap Value A (FRVLX) had a short-term capital gain distribution of 0-3% and a long-term capital gain distribution of 7-13% of the fund’s net asset value (NAV) on December 14, 2017. Based on the fund’s closing NAV on that day of $59.42, the short-term distribution could have been as high as $1.78 per share and a long-term distribution as high as $7.72 per share. Therefore, any shareholders that held this fund in a taxable account would see as high as $9.50 of every share held taxed at capital gains rates. On the contrary, shareholders that have this fund in a tax-advantaged fund would not have to worry about this issue, as the capital gains would not be taxed.

One thing to point out is that the record date for the fund was on December 14, 2017. Any investor who held this fund on that date would then be subject to the capital gains distribution, regardless of when they first bought in. Knowing when and how much a mutual fund will distribute for its capital gain is important information to any investor looking to buy in a taxable account.

Want to know the different types of mutual fund distributions? Check here.

Another issue with mutual funds is that the fund manager is required to distribute its capital gains, regardless of market conditions.

Generally, capital gains are a byproduct of a bull market, wherein both the underlying holdings and the fund itself are seeing high profits. However, with mutual funds, capital gains will be passed in bear markets as well. In the example of the Franklin Small Cap Value Fund A, the fund was up 1.6% for 2017. So, in this instance, if an investor bought the fund within a standard taxable account on January 1, 2017, and held it till December 31, 2017, the fund would have provided a total return of only 1.6% but be taxed on up to 13% of the fund’s NAV.

Can investors purchase mutual funds outside of a tax-advantaged account? Yes, but only if they do their research.

Mutual fund investors should always be alert of when and how much a mutual fund’s capital gain distribution is. Not being aware of this could seriously cause unnecessary taxation, which could undermine the purpose of the investment in the first place. When deciding to purchase mutual funds, investors should consider using tax-advantaged accounts instead of taxable accounts. Other investments, like ETFs or individual stocks, are considered more tax efficient than mutual funds and should be considered in taxable accounts.