Capital Gains Taxes Trap: How to Avoid Mutual Fund Tax Bombs
It’s bad enough when your mutual fund’s assets lose value, but owing unexpected capital gains taxes after those losses is doubly frustrating.


Many know that capital gains taxes are what you owe when you sell an investment that has gained value since you bought it. What’s less well-known is that you can end up owing capital gains taxes on an investment that has lost value since you purchased it and that you haven’t even sold!
Getting caught in that capital gains tax trap has led many to unpleasant and expensive surprises come tax season. There’s a way to avoid this problem, but only if you understand why it happens.
Mutual Funds: Popular Investments, With Pitfalls
Mutual funds are attractive because they provide automatic diversification. Rather than having to buy dozens of different assets in order to diversify your portfolio, you can buy into a mutual fund that already owns a wide variety of assets.

Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
But because of how they’re structured, there are some interesting caveats to consider. When another investor in a mutual fund decides to sell their stake, the mutual fund has to pay them the value of their shares. Because the mutual fund itself doesn’t usually maintain large amounts of cash assets, when it owes money, it must raise those funds by selling its assets.
If those assets are worth more when the mutual fund sells them than they were when it bought them, the fund will owe capital gains taxes that its remaining members must pay. Members with large stakes in a mutual fund that sells a lot of assets that have greatly appreciated in value can find themselves owing tens of thousands of dollars in capital gains taxes, even if the overall value of the mutual fund went down in that tax year!
You might think an easy way to save members from owing large tax bills at the end of the year would be for a mutual fund to structure its asset sales such that some are sold at a loss in order to offset the assets that gained in value via tax-loss harvesting. You’d be right! Balanced selling would be a good solution, but for many mutual funds, there’s an incentive not to do that.
Highly Focused on Performance Metrics
Mutual fund performance metrics are based on how much value the mutual fund’s assets gain. Selling only assets that have gained in value increases the mutual fund’s performance assessment. Investors looking for a mutual fund to buy into are understandably more likely to choose one that reports highly positive performance than one that reports middling or negative performance.
In order to attract new investors by showing the highest performance possible, mutual funds often make decisions that negatively impact their current investors’ tax picture. There are several ways to avoid this problem:
If your mutual fund is part of an employer-sponsored 401(k), you’ll automatically avoid it because those accounts have different tax regulations that, by default, shield them from capital gains when funds inside them sell assets.
If you wish to invest in a mutual fund outside of an employer-sponsored account, look for a “tax-efficient” mutual fund. These funds take into account the tax burden they’re imposing on their investors when making divestment decisions.
However, these funds still have the fundamental weakness of you not being in control of what they do. You are relying on the decisions of the fund managers to make your investment worthwhile. Fund managers will naturally make decisions that prioritize the survival of the mutual fund itself rather than focusing on the tax implications for their investors. If those decisions aren’t in your favor, your retirement savings can suffer.
Avoiding the Tax Bomb: ETFs
Another option, and one we often steer our clients toward, is to avoid the mutual fund altogether and instead consider an ETF. In the past, people invested in mutual funds for diversification, even with small investments. Being able to spend $1,000 to invest in 3,000 companies is attractive because of the automatic diversity of your investment.
Today, ETFs do the same thing, but you avoid the risk of stumbling into the capital gains trap. We much prefer to see our clients invest in individual securities and ETFs for their taxable retirement accounts. The investor can derive the same portfolio diversity as with a mutual fund while gaining the ability to direct their investments personally. We feel that, when possible, it’s good practice to be completely in control of your investments.
It's Important to Work With a Fiduciary
The mutual fund tax bomb is one that’s often encountered by people whose financial professionals lack an individualized approach to each client and who have been incentivized to sell certain products — it’s common to encounter investment firms that are motivated to sell certain products.
If a broker receives a commission every time a client invests in a mutual fund, there’s a natural tendency for that broker to want every client to invest in that mutual fund! That’s why it’s important to choose an independent fiduciary adviser who does not get paid based on which products their clients choose. Only with such independence can a client be confident that their interests are prioritized over their adviser’s profits.
Get Kiplinger Today newsletter — free
Profit and prosper with the best of Kiplinger's advice on investing, taxes, retirement, personal finance and much more. Delivered daily. Enter your email in the box and click Sign Me Up.
As Principal and Director of Financial Planning, Sam Gaeta helps clients identify financial goals and make plan recommendations using the five domains of financial planning — Cash Flow, Investments, Insurance, Taxes and Estate Planning. He is responsible for prioritizing clients' financial objectives and effectively implementing their investment plans and actively monitors the ever-changing nature of clients' financial and investment plans.
-
RMD Deadline April 1: Five Tax Strategies to Manage Your 2025 Income
Taxable Income The April 1, 2025, deadline for required minimum distributions (RMDs) is fast approaching for retirees who turned 73 in 2024.
By Kelley R. Taylor Published
-
Rising AI Demand Stokes Undersea Investments
The Kiplinger Letter As demand soars for AI, there’s a need to transport huge amounts of data across oceans. Tech giants have big plans for new submarine cables, including the longest ever.
By John Miley Published
-
The Three Biggest Fears Keeping Retirees Up at Night
Here are the steps you can take to put those fears to rest and retire with confidence so you can relax and enjoy the life you've planned.
By Pam Krueger Published
-
What Can a Donor-Advised Fund Do for You? (A Lot)
DAFs and private foundations go about helping charities (and those who donate) in different ways. Each comes with its own benefits and restrictions to navigate.
By Julia Chu Published
-
Estate Planning When You Have International Assets
Estate planning gets tricky when you have assets and/or beneficiaries outside the U.S. To avoid costly inheritance mistakes, it pays to understand the basics.
By Kelsey M. Simasko, Esq. Published
-
Three Essential Estate Planning Steps to Protect Your Nest Egg
After dedicating years to building your wealth and securing your future, make sure your assets are protected and your loved ones are provided for in the future.
By Nicole Farbo, CFP® Published
-
Is Chasing the American Dream Ruining Your Financial Life?
Too many people focus on visible affluence as a marker of success. Here's how to avoid succumbing to the pressure and driving yourself into debt.
By Anthony Martin Published
-
Retiring With a Pension? Four Things to Know
The road to a secure retirement is slightly more intricate for people with pensions. Here are four key issues to consider to make the most out of yours.
By Joe F. Schmitz Jr., CFP®, ChFC® Published
-
How to Teach Your Kids About the Tax Facts of Life
Taxes are unavoidable, so it's important to teach children what to expect. Also, does your child need to file a tax return for 2024? Find out here.
By Neale Godfrey, Financial Literacy Expert Published
-
Revocable Living Trusts: The Good, the Bad and the Ugly
People are conditioned to believe they should avoid probate at all costs, but when compared with living trusts, probate could be a smart choice for some folks.
By Charles A. Borek, JD, MBA, CPA Published