As you will see in the Paying Taxes on Mutual Funds with Losses video, mutual funds�especially actively managed mutual funds�generate a lot of taxable events, and the profits and losses are passed directly to the owners of the mutual fund. [To learn more about how mutual funds work, check out our article and video on Mutual Funds.]

How On Earth Could You Owe Taxes on a Mutual Fund That Lost Money?

Owing taxes on a mutual fund that lost money seems impossible. But thanks to Uncle Sam and the IRS (Internal Revenue Service), it happens more often than many investors realize. Here's how it works:

Taxable capital gains are passed on to the owners of a mutual fund�investors like you�when the fund manager sells a stock, or other asset, that is held within the fund for a gain. For instance, if the fund manager for a large-cap mutual fund like the American Funds AMCAP Fund (AMCPX) or the T. Rowe Price Blue Chip Growth Fund (TRBCX) bought shares of Google (GOOG) for $200 per share and then sold those shares for $300 per share six months later, it would generate a $100 taxable gain that would be passed along to you.

Initially, this looks like a good thing. The mutual-fund manager made money on a trade. However, if the rest of the trades within the fund caused the mutual fund to lose value overall, you would lose money on the fund and still have to pay taxes on the Google trade.

Why Would a Mutual-Fund Manager Sell Stocks?

Now, there are basically two things that can cause a mutual fund manager to sell stocks within the fund:

1. Management decisions to move into stocks that offer more potential profit

2. Mutual fund redemption