I'm a Financial Adviser: This Tax Trap Costs High Earners Thousands Each Year

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If you're a high-income investor, your brokerage account could be quietly working against you.

Mutual funds, long considered a cornerstone of diversified investing, can trigger surprise tax bills that eat away at returns. The reason lies not in your investment performance, but in the structure of the funds themselves.

The problem: A tax bill you can't control

When you own a mutual fund, your money is pooled with the funds of thousands of other investors. The fund manager actively buys and sells stocks or bonds within that pool. When appreciated securities are sold, those gains must be distributed to shareholders each year under federal law.

That sounds straightforward until you realize two major drawbacks:

No control over timing. The manager's sales decisions are driven by portfolio strategy and redemptions, not your personal tax situation. You can end up realizing gains even when you didn't sell anything.

"Phantom" gains. You can owe taxes even if your fund's value drops. If the manager sells appreciated holdings to meet redemptions, those gains are still passed to remaining investors.

In short, you're paying for someone else's selling decisions and possibly paying taxes on income you never pocketed.

A painful lesson from 2022

This dynamic became painfully clear in 2022, when the S&P 500 fell nearly 20%. Many investors saw their portfolios lose value, yet still received capital-gain distributions.

Actively managed funds had to sell appreciated positions to meet investor withdrawals during the downturn.

Consider the Growth Fund of America (AGTHX). It lost roughly 25% in 2022 but still distributed $3.71 per share in long-term capital gains that December.

Investors were hit twice: a shrinking portfolio and a tax bill on "phantom" gains.

The triple drag: Loads, taxes and fees

Let's break down the hidden costs with a real-world example from The Growth Fund of America®.

• Front-end load. Class A shares charge up to 5.75%. A $100,000 investment could lose $5,750 before the money even hits the market.
• Tax drag. In December 2024, the fund distributed $1.15 per share in dividends and $6.38 in long-term capital gains. For a high-income taxpayer, that could mean roughly $1,900 in federal taxes, according to IRS Publication 550 and Topic No. 559 (net investment income tax).
• Expense ratio. The annual 0.61% fee equals $610 on $100,000.

Combined, the first-year headwind can be staggering. Add the $1,900 tax and $610 fee to the $5,750 sales charge, and your $100,000 investment effectively starts 8.25% behind.

Smarter, tax-efficient alternatives

High-income investors don't have to accept this structural disadvantage. More efficient tools can help reduce taxable drag and improve after-tax returns.

Exchange-traded funds (ETFs). ETFs generally avoid distributing capital gains because of their in-kind redemption mechanism. That structure allows managers to swap appreciated securities out of the fund without triggering taxable events.

Combined with typically lower expense ratios, ETFs are often the better choice for taxable accounts.

Separately managed accounts (SMAs). An SMA gives you direct ownership of the underlying securities. That ownership allows for individualized tax-loss harvesting, which can offset gains elsewhere in your portfolio.

For investors with significant assets and complex tax situations, this added flexibility can be valuable.

Direct indexing. Direct indexing takes tax efficiency a step further. Instead of buying a single fund, you hold the actual stocks of an index. Your adviser or manager can harvest losses from specific positions while keeping overall exposure aligned with the benchmark.

This granular control can meaningfully reduce taxable income over time.

The bigger idea: Asset location matters

Tax efficiency isn't just about what you own, it's about where you own it. Growth-oriented or high-turnover funds belong in tax-advantaged accounts, such as IRAs or 401(k)s.

Your taxable brokerage account should be designed with low-turnover, tax-efficient investments.

This concept, known as asset location, can make a measurable difference. Studies consistently show that thoughtful asset location can boost after-tax returns by 0.5% to 1% per year, a compounding advantage that grows over decades.

The bottom line

If your taxable accounts are filled with actively managed mutual funds, you might be losing money to taxes you can't control. ETFs, SMAs and direct indexing can give you back that control while improving efficiency.

Your portfolio isn't just a collection of investments; it's a financial ecosystem that must work together across account types. By being intentional about structure and location, you can stop the silent erosion and keep more of what you earn working toward your future.

Josh Taffer is a Founding Partner and Wealth Advisor of Journey Wealth Strategies and is an investment adviser representative of Signal Advisors Wealth, LLC ("Signal Wealth"), a Registered Investment Adviser with the U.S. Securities & Exchange Commission.

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.