How a mutual fund works
An SEC-registered investment adviser manages the pooled portfolio, and each share is a proportionate slice of it, gains and losses included. Open-end means the fund sells new shares whenever investors want them and buys them back, or redeems them, on demand, so the number of shares outstanding rises and falls with demand.
Mutual funds must price their shares every business day, and they typically do so after the major US exchanges close. Every order is filled at the next NAV calculated after you place it, so a purchase entered at 10 a.m. gets the same price as one entered at 3 p.m., and you won’t know that price until the evening. You can buy directly from the fund company, through a broker, or through a workplace plan such as a 401(k).
A mutual fund is one of three kinds of investment company. A closed-end fund sells a fixed number of shares once, and they then trade between investors; a unit investment trust makes a one-time offering of a fixed number of units. An exchange-traded fund is usually organized as an open-end fund too, but its shares trade on an exchange instead of with the fund.
How you earn money, and why you can owe tax without selling
A fund pays you in three ways: dividends from the interest and dividends its holdings earn, minus expenses; capital gains distributions after it sells holdings at a profit; and a rising NAV.
In a taxable account, the second one is the catch. The law requires funds to distribute their net realized gains, so you can owe tax in a year you never sold a share, and even in a year the fund lost money. The IRS treats these capital gain distributions as long-term capital gains no matter how long you have owned the fund, and they are taxable even when reinvested. Ordinary dividends are taxed as ordinary income unless they count as qualified dividends. Selling shares is a separate taxable event, and the IRS says exchanging shares of one fund for another is taxable too, even within the same fund family.
Keep track of your cost basis, including every reinvested distribution; for mutual fund shares you may elect the average-basis method. Inside a 401(k) or IRA, none of this is taxed as it happens.
Types of mutual funds
Funds are grouped by what they hold and how they are managed. An index fund tries to match a market index at low cost, trading rarely. An actively managed fund tries to beat a benchmark by buying and selling at the manager’s discretion, so its results depend heavily on that manager’s skill, and it usually costs more. Either style can hold any of the main types, so read the prospectus rather than relying on a fund’s name:
- Stock funds: invest mainly in Stocks; their value can rise and fall quickly and sharply.
- Bond or income funds: invest in Bonds and other debt, with risk that varies by credit quality and duration.
- Target-date funds: shift from stocks toward bonds as a target year nears; if they hold other funds, you may pay two layers of fees.
- Money market funds: hold short-term debt; often used to park cash, but they are not bank deposits.
- Tax-exempt funds: hold municipal bonds, so some or all of their dividends escape federal income tax; capital gains are still taxable.
Pros, cons and common mistakes
The case for a mutual fund is convenience: one purchase buys a diversified, professionally managed portfolio in exact dollar amounts, since funds issue fractional shares, with automatic reinvestment and redemption on any business day. The drawbacks: you trade once a day at a price you don’t know in advance, some share classes carry loads and 12b-1 fees, and in a taxable account the fund’s own trading can hand you capital gains you did not choose.
Timing can make that last one worse. A distribution lowers the NAV by the amount paid out, so buying just before a year-end distribution in a taxable account hands part of your own money back to you as taxable income. Repeated every year, distributions are a form of tax drag that ETFs and index funds usually keep smaller. Also watch for:
- Paying a Class C share’s higher annual expenses for many years when a lower-cost class was available.
- Missing a breakpoint discount you qualified for.
- Switching funds within a family as if the exchange were tax-free.
- Forgetting reinvested distributions in your cost basis and paying tax on them twice.
Illustrative numbers
A capital gain distribution in a taxable account
- Fund assets
- The market value of everything the fund owns, including cash
- Fund liabilities
- What the fund owes, such as accrued expenses
- Shares outstanding
- All shares held by investors at the time of the calculation
Fund expenses are paid from assets, so they lower NAV instead of arriving as a bill.
Shares owned1,000 at a NAV of $20.00 = $20,000
Year-end capital gain distribution$1.50 a share = $1,500
NAV after the payout$18.50, so the shares are worth $18,500
Distribution reinvested$1,500 buys about 81.08 shares at $18.50
Account value after reinvestingAbout $20,000 (1,081.08 shares × $18.50)
Federal tax at a 15% long-term rate$225
Your wealth did not change, yet you owe $225 because the fund realized gains inside its portfolio. The reinvested $1,500 raises your cost basis, so record it, or you will pay tax on it again when you sell. In an IRA or 401(k), the same distribution would not be taxed.
At a glance
Common mutual fund share classes compared
| Class | Sales load | Ongoing costs | What to check |
|---|---|---|---|
| Class A | Front-end load at purchase, often reduced at breakpoints | Lower 12b-1 fee and annual expenses than B or C shares | Whether your investment reaches a breakpoint |
| Class B | No front-end load; a deferred sales load that shrinks the longer you hold | 12b-1 fee; may convert to a lower-cost class after enough years | The deferred sales load schedule and conversion date |
| Class C | A smaller front-end or back-end load | Higher annual expenses than A or B shares; generally no conversion | The total cost if you hold for many years |
| No-load | None | Operating expenses; may still charge purchase, redemption, exchange or account fees | The full prospectus fee table, not the label |
Put it in your plan
Mutual fund in MoneyWhatIf
In MoneyWhatIf, a mutual fund is modeled through the account that holds it. For a stock fund, set the account’s growth and dividend rates or let it follow the plan’s shared assumptions, and enter the fund’s expense ratio as the yearly fee. For a bond fund, give the account a bond allocation and choose its bond type: taxable, Treasury, own-state municipal or national municipal, the last treated as federal-exempt but state-taxable. These are simplified categories; the model does not read a particular fund’s holdings or its state-exempt percentage.
Common questions
Mutual fund FAQs
What is the difference between a mutual fund and an ETF?
Both are registered funds that can be index or actively managed. You buy mutual fund shares from the fund at the next end-of-day NAV, in exact dollar amounts, with distributions reinvested automatically. ETF shares trade all day on an exchange through a brokerage account, rarely carry loads or 12b-1 fees and, in a taxable account, typically distribute fewer capital gains.
What happens if my mutual fund converts to an ETF?
The fund will notify you, and the value of your investment does not change at conversion. Shares already held at a broker convert automatically; shares held directly with the fund need a brokerage account. Fractional shares may be cashed out first, which can be taxable, and multiple share classes are typically consolidated. Conversions are generally structured to be tax-free, but sales before the switch can trigger a capital gain distribution.
Are mutual funds safe?
Mutual funds are not guaranteed or insured by the FDIC or any other government agency, and you can lose money in them, including in bond funds. Their protections come from regulation, such as SEC registration and required disclosures, and from Diversification across many holdings. If the brokerage holding your shares fails, SIPC can restore missing shares up to its limits, but it never covers a fall in value.
How quickly can I get my money out of a mutual fund?
You can redeem shares on any business day at the next calculated NAV, minus any redemption fee or deferred sales charge. The fund must send your payment within seven days, and many pay sooner. Redemption fees, when a fund charges them, are paid into the fund rather than to a broker, and SEC rules cap them at 2% of the amount redeemed.
Should I choose a mutual fund by its past performance?
Past performance is a weak guide on its own. The SEC notes that past returns do not predict future returns, although they do show how volatile a fund has been. Costs, by contrast, are certain: a fund with higher expenses must earn more just to match a cheaper one. Comparing funds with the same objective on fees, holdings, risk and tax efficiency tells you more.