Understanding financial side effects

  • March 19, 2018

BY: BYRON MOORE, CFP®

posted March 19, 2018

 

Question: Do you pay taxes on money you make when it’s in a mutual fund?

Answer: Generally speaking, yes.

I’m pretty sure every program on network television is currently being funded by drug company commercials.

You know the kind I’m talking about. A happy, mmm…mature person…is living the good life, gardening, playing with grandchildren, slowly cycling down the sunlit path with their equally contented, healthy-looking spouse or friend.

A silky-voiced announcer explains how some new wonder drug with a quirky name can help your mood, your bloating, your bowels, your kidney function, your eyesight, how your left big toe feels and (of course) your sexual function.

Then comes the fun part.

Once the commercial has you drawn into the wonderful world of the happy people taking this drug, the announcer continues in a trance-like drone, “CureItAll should not be taken by pregnant women, ugly men or anyone with hairy feet. In some cases, CureItAll has been found to cause sleeplessness, drowsiness, hay fever, bad breath, suicidal thoughts and sudden death. Ask your doctor about CureItAll.”

There must be a law against financial companies running these kinds of commercials. They’ve got as much money as drug companies and most of their products can’t actually kill you (except in rare, rare cases).

If they did, they would have to have their own side effect warning.

“Richuvenex should not be taken by people with weak stomachs or short-sightedness. Richuvenex has been known to cause sudden onset euphoria, followed by bouts of depression. Richuvenex causes taxes to increase and often at very inconvenient times. Richuvenex can cause your wealth to grow, but it can also cause it to shrink. Richuvenex has been known to shorten life spans and cause sudden onset panic attacks. Ask your financial advisor about Richuvenex (but don’t believe everything he says!).”

We all know the medical and pharmaceutical world is full of side effect warnings. Perhaps the financial world should be as well.

If you have an individual investment account (not an IRA or some other form of tax-advantaged account), you will almost certainly owe taxes on the growth of your investments – though the timing and amounts will vary widely.

Most small investors do most of their investing through mutual funds. It’s convenient and relatively affordable for almost anyone who wants to invest.

A mutual fund that invests in stocks, for example, will try to own stocks that will grow over time. Those stocks may pay dividends. A particular stock owned by the mutual fund may grow suddenly and the fund decides to sell quickly. Or the fund may pick a stock they decide is a long-term winner and keep it for years. Finally, the fund may own some bonds or other interest-bearing instruments.

In the paragraph above, I described four different tax scenarios and four different tax rates experienced by an individual investor investing in a mutual fund in a taxable account. The combinations are nearly endless.

What many investors fail to fully appreciate is that no one invests in a vacuum. As a taxable investment account compounds in growth, the taxes owed on the account tend to compound along with it.

I was looking at a situation recently where someone was investing $1000 per month into a mutual fund. He wanted to see the impact of taxes on the fund.

On the positive side, over the 30 year period under consideration, the $360,000 he would have invested (that’s a grand a month for 30 years), would have grown to about $1.7 million. Not bad.

But not the whole story either. In order to have the $1.7 million, he would have had to come with more than the grand a month. He would have had to come up with nearly $600,000 more over the 30 year period to pay all the taxes due as the account grew!

Once you take into account the cost of the additional taxes, what looked like an 11% return (in a vacuum) is really more like a 5% return…with all the risk of the stock market.

Does that mean never invest? Nope.

But understand the side effects. They can be quite taxing.

 

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