Investment Company Institute (ICI) has a very good FAQ section on taxation of Mutual funds. Especially the last question on how timing of buying mutual funds can affect the amount of taxes one pays. Essentially what it says is that the distribution of returns by the funds affects the timing of taxes you pay but the amount of tax one pays is not affected by when you buy or when the profits are distributed. In a world where there is no concept of time value of money, timing of distribution of profits by MFs do not affect your profits otherwise they might.
“Is it true that mutual fund shareholders have to pay “someone else’s taxes” if they buy fund shares at a certain time?
No—fund shareholders do not pay someone else’s taxes. Every fund shareholder is taxed only on his or her own economic income over the life of the investment.
Shareholders purchase and sell a fund at the fund’s net asset value (NAV), which is calculated daily. A fund accumulates realized and unrealized capital gains, interest, and dividends until it makes distributions. These gains and income increase the fund’s NAV until they are distributed. A fund distribution reduces the fund’s NAV; thus, amounts that are distributed reduce the gain (or increase the loss) that a shareholder realizes when fund shares later are sold.
Assume an investor purchases fund shares on Monday for $10 per share. The fund distributes a $1 capital gains dividend (attributable to previously realized gains accrued in the fund’s NAV) on Tuesday. The $1 distribution reduces the fund’s NAV to $9. If the investor sells the fund shares on Wednesday for $9, the investor will have no gain or loss.
- No economic gain or loss: The investor purchased the fund for $10, and received a $1 distribution and $9 upon the sale of the shares. Thus, the investor paid $10 and received $10, for no net gain or loss.
- No taxable gain or loss: The $1 of capital gains distributed (on which tax would be due) is offset fully by the $1 loss realized when the shares purchased for $10 are sold for $9. Thus, the investor has no taxable gain or loss.
For a more detailed illustration, consider the following two scenarios:
Scenario 1: Assume that Investor A bought 100 shares of a fund for $10 a share. The shares rose in value to $20. Investor A then sells her shares, and owes taxes on $1,000—the capital gain of $10 a share times 100 shares. Investor B buys 100 shares at the fund’s new NAV of $20 a share, which includes the embedded gains. If the shares rise to $30 a share, and Investor B sells his shares, he would owe taxes on $1,000—the capital gain of $10 a share, times 100 shares. In other words, Investor A owes taxes on the $10 gain accrued while she owned the fund, and Investor B owes taxes on the $10 gain accrued while he is invested. Each shareholder is paying for his or her own gains earned.
Scenario 2: Now assume this same set of transactions occurs, except that the fund distributes its $10 accrued gain on the day after Investor B bought his shares at $20. Investor A still owes taxes on $1,000—the $10 gain on her shares, bought at $10 and sold at $20, times 100 shares. Investor B must now pay taxes on $1,000—the $10 per-share distribution, times 100 shares. The distribution reduces the fund’s NAV to $10. If Investor B pays the taxes from other assets and reinvests the full amount of the $1,000 distribution, he will now own 200 shares. The first 100 shares were purchased at $20 a share, while the second 100 were purchased at $10 a share. Investor B’s average cost basis for tax purposes is $15 a share.
The shares then rise by 50 percent, as in Scenario 1, to a new value of $15 a share. When investor B sells his 200 shares at $15 a share, for tax purposes he is treated as having purchased all those shares at his average cost basis of $15 per share. Thus, he has no new tax liability because he has already paid taxes on his own gain.
Is Investor B paying Investor A’s taxes when he pays taxes on the $1,000 distribution? No. Investor A paid her own taxes on the $1,000 gain when she sold shares at $20 with a cost basis of $10; she delayed paying taxes until she sold. Investor B paid taxes on the $1,000 distribution up front, but owed no additional taxes when he sold his shares with the same price ($15) as his cost basis. Thus, he pays taxes only on the $1,000 that he earned while he owned the shares.
Compared to other forms of investments, the only issue with a mutual fund is the timing of the taxes paid, not the amount of taxes paid. Taxes may be paid sooner (if gains accrued before purchase are realized and distributed) or later (if losses accrued before purchase offset realized gains), but total taxes paid will be the same.”
Here is another article in Forbes on taxation of mutual funds. In India the tax rules are very simple.The amount of taxes an individual pays is only dependent on amount of time he invests his money in the fund and not on the amount of time the fund holds its assets. This article and this article explain the taxes one has to pay at individual level in India. However this means people can game the system. If I have a strategy which entails high turnover it would make sense for me to float a mutual fund and invest the my money through mutual fund. This way I will avoid short term capital gains tax and pay long term capital gains tax which is generally less than the former.