 Hello and welcome to this session in which we would look at the taxation of mutual fund. In the prior session we looked at fees that mutual fund charges and we said it's important to know how much profit you are making after fees, but also it's important to know how much profit after paying taxes because Uncle Sam's gonna come over and take part of that profit. So you want to understand how mutual fund are taxed. This topic is typically covered in an essentials or principles of investment scores whether it's an undergraduate or graduate course. As always I would like to remind you to connect with me on LinkedIn. If you haven't done so, YouTube is where you would need to subscribe. I have 1700 plus accounting, auditing, tax, finance, as well as excel tutorial. If you like my lectures please like them and share them. If they benefit you, it means they might benefit other people, share the wealth, connect with me on Instagram. On my website farhatlectures.com you will find additional resources, the supplement and compliment your accounting as well as your finance courses. I strongly suggest you check out my website, especially if you're studying for your CPA, CFA or CMA exam. The first thing we want to know about the taxation of mutual funds is mutual funds has a pass-through status. Now, it's very important to understand what does that mean? It's a tax term. Pass-through means the profit passes through to the investors. So simply put, we have a mutual fund company. So this is the mutual fund company. That's fine. Now all the operations happen in this mutual fund. They buy, they sell, they buy, they sell, they make profit. Well, guess what? All this profit is passed to the let me put it as individual. This way it makes more sense. All this profit, sorry about my my drawing. This is my best. All the profit is passed through to the investors. This is what a pass-through entity is. It means the company itself pay no taxes on whether you have a gain, dividend or if you have losses, everything is passed to the investors. That's what we mean by pass-through entity. So simply put investment of investment returns of mutual fund are granted pass-through under the US tax code. Taxes are paid only by the investor in the mutual fund, not by the fund itself as I just showed you a minute ago. The income is treated as pass-through to the investor as long as the fund meets several requirements. You have to meet several requirements. Obviously mutual fund will meet those several requirements. Basically the fund will have to be diversified and you practically have to distribute all your income to the to the shareholders. So you cannot keep that income. Okay, if you keep that income, okay, let's think about why just because it's it's very important to understand why. If the mutual fund, remember the mutual fund company, if the company keeps the income, income is not taxed. Well, Uncle Sam says no, no, no, no. This is not a good thing. What's happening? The mutual fund, the mutual fund company is making gains, capital gains, and it's not distributing the income. Well, if that's the case, the mutual fund company doesn't pay taxes. So it's like you're hiding your taxes. So in order to get that pass-through status, you have to distribute that income to shareholders. Okay. So funds, they could have short-term capital gain, long-term capital gains dividend. They are all passed through to the investors and the investors will have to pay taxes on those. Now what is short-term gains versus cap, a long-term capital gain? Well, if you hold the security for less than a year at short-term, if you hold it longer than a year, it's long-term. Now, why do we have to differentiate between short-term and long-term? It's because they are treated differently for tax, for tax status. So short-term, they have a higher tax, tax bracket than long-term. But again, if you're interested in this topic, go to my income tax course. But simply put, what happened is this, at the end of the year, you would receive what's called the 1099 dividend and distribution format, look something like this. If you have any dividend, any capital total gain distributed, if there's any, sometimes if there's any federal income tax, what held, if there's any, if you, if there is any exempt interest dividend, if there's any foreign taxes paid from the fund. So basically everything passed through to the investor. And the investor will take this form and will prepare their taxes. Now, the good news is, the good news here is that the tax is paid once. So the mutual fund doesn't pay taxes, then the investor pay taxes. So simply put, the tax is gained, is taxed once, the gained is taxed once. That's the good news. What is the bad news? The bad news is the investor don't have the option to time their gains. Simply put, let's think about it. If you own a stock, okay, what does that mean? It means if you own it, if it goes up in value, you don't have to pay taxes. Once you sell it, you have to pay taxes. Well, you determine when you pay your taxes. That's when you sell it. When it comes to a mutual fund, you don't have that option. You don't have the timing option. What does that mean? It means when the mutual fund company sells the stocks inside the mutual fund, inside the portfolio and generate capital gains, well, the capital gains is passed through to you. It's like they're making decision on your behalf and that decision on your behalf is giving you tax consequences. So sometime you may not be aware that you might be hit with a large tax bill because your mutual fund sold a lot of stocks and they generated gains. So the pass-through of investments have one important disadvantage for individual investor and that is if you manage your own portfolio, your own stocks, you decide when to realize capital gain. Realize it means when the transaction to actually takes place, when you sell it. And if you have losses too, you could realize the losses. So you can time. That is the important concept. You can time those realization to efficiently manage your tax liability and that's extremely important. As an investor, you want to be in control of when and how much you pay taxes. With the mutual fund, that's not the case. The timing of the sale of the securities is out of your control. That's the disadvantage of having a mutual fund. What does that mean? It means it reduces your ability to engage in tax management. What you can do if you have a mutual fund, you can tell the fund to withhold taxes. If you want them, notice here, box four, you'll tell them, you know, withhold taxes. This way you're paying the taxes on the profit. You do have that option if you want to. So this is the disadvantage of a mutual fund, the timing. Also, another disadvantage is what's called turnover. Okay. So a fund with a high portfolio turnover can practically be tax inefficient. What is a turnover? Turnover is when they constantly or they buy and sell. When they buy and sell, there's a turnover. They're turning over the securities. They sell Tesla, they buy Apple, they sell Apple, they buy Amazon, they sell Amazon, they buy GE. Okay. Turnover is the ratio of trading activity of a portfolio to the asset of the portfolio. Well, it's measured as a fraction of the portfolio that's replaced at each year. So how much of your portfolio is replaced? You sell it, then you replace it. So basically when you sell it, you replace it. How much is that relative to the portfolio itself? Okay. For example, if you have a hundred million dollar portfolio with 50 million in sales of the securities and purchases of other securities, you'd have a turnover of 50%. So you sold half of your securities and you bought them. Well, high turnover means capital gains or losses are being realized constantly. What does that mean? It means the investor and that fund, they will have tax consequences and those tax consequences, they cannot time. Okay. So therefore, the investor cannot time the realization to manage his or her tax obligation. Okay. Until recently, just so you see what's going on here. Obviously, obviously the investors don't like this turnover and equity funds has typically been around 60% when weighted by asset under management. But you can tell what's going to happen. By contrast, a low turnover fund such as index fund. Remember, index fund, they don't have a turnover. They buy the S&P stocks and they sit on them. They could have a turnover as low as 2%. Why would they have some time turnover if one company leave the S&P and another one replace it? Then they will have to sell the stocks of the old company. Let's assume GE left the S&P 500 was replaced by Tesla. Then they'll have to sell GE stocks and replace it by Tesla. So the fund represent the index. Okay. In the last few years, I mean, this is not as recent as recently as that weighted average turnover has dropped considerably to 34% in 2016. Part of the decline is basically because you have people shifting from actively managed portfolio to index fund. Because in the index fund, you don't have to worry about not worry. Yes, exactly. You don't have to worry about determining what's the optimal portfolio. Just buy the S&P 500, buy all the stocks in the S&P 500, have the index, track the S&P 500, and you will do as well as the economy. Your investors are happy. You're pretty diversified and you're, quote, safe. Also, with the taxes, you always have to worry about future tax rate. Because if you have a portfolio and the tax rate goes up, then your tax bill is going to be higher. So it's something that you have to be aware of when you invest in a mutual fund. And the best way is to talk to your CPA or your tax consultant, persons like myself, or look at my income tax scores. The SEC, the SEC have few regulations about mutual funds that require the fund to disclose the tax impact of the portfolio turnover. So you are required and your prospectus, just kind of let the potential buyers know what are the consequences for the portfolio turnover. Because that's going to give you a different tax bill. So the fund must include, in their perspective, after tax return, one, five, and 10-year period. So they have to show you that. Marketing literature that include performance data must also include after-tax results. So remember, and each individual is taxed differently because each individual will have a different tax bracket. So the after-tax return are computed accounting for the impact of taxable distribution of in-capital gain passed through to the investors. Assuming the investor is in the maximum federal tax bracket. So to make it the worst-case situation, what they say, say, tell the investor, for example, they might say you might be paying 30%, but in reality, that's the maximum. In reality, you could be paying only 10 or 15, depending on your tax bracket, okay, or could be 20%, depending on your tax bracket. So simply put, different people are taxed differently based on their capital gain. What is that based on? It's based on your tax bracket. What is your tax bracket based on? Based on your income in each, each on your taxable income. And each individual will have different taxable income and different type of taxable income. Because under taxes, you have active income, portfolio income, passive income, you have different type of income, and each income is taxed differently. So the point, the point is, I don't want to, because I teach taxes, I don't want to go there, the point is each individual will have a different tax bracket. The SEC tells you, show them the maximum. Treat as this individual is kind of, let's put the word in quote rich, they have a lot of income. What's the worst-case situation for their tax impact? Okay, let's take a look at a quick example to see how the turnover and taxes work. An investor's portfolio is currently worth one million. During the year, the investor sells 1,000 shares of FedEx at a price of 150 and 10,000 shares of Cisco for a price of 250. The proceeds bought 2,500 shares of IBM. So simply put, you have a million, you sold, here we're talking about 15 and four zeros, 150,000, and you sold Cisco for 250,000, total sales were 400,000. What you did, is you replaced them with IBM. So what's your turnover? Well, your turnover, if you have a million dollar portfolio and you sold and you replaced 400,000, your turnover is 40%. If the shares of the FedEx were originally purchased at 140 and Cisco were purchased at 20, so basically you made $10 on the FedEx shares, then $10 times a thousand. So you made $10,000 profit and here you sold them at 25, you made $5 per share and you sold 10,000 shares, you have 50,000 in gains, so totally you have $60,000 in gains. And if the investor tax rate on the capital gain is 15%, that's the maximum, but that's the 15%, how much extra will the investor owe this year on their taxes? So we're talking about 60,000 of profit times 0.15, this is what they're looking for. So you pay in total your tax bill on this portfolio is $9,000. Now in the next session we would look at another topic, exchange traded fund, which is in my opinion, it's starting to replace more and more mutual fund, it's more flexible. I like exchange traded funds, actually I do trade them on a regular basis, I do trade two exchange traded funds, I will not name them, just FYI I do trade exchange traded funds. We'll look at this topic as always, if you like this recording, please like it, share it with your friends, again if it benefit you, if this recording is what's beneficial to you, it means it might benefit your friends as well, so please share it and don't forget to visit my website farhatlectures.com for additional resources for this course as well as other courses. Good luck, study hard and stay safe.