Can I Move Money Between Mutual Funds Without Paying Taxes?
Exchanging mutual funds is often a taxable event. Learn how the account you use, such as a brokerage or an IRA, determines if you owe capital gains tax.
Investors frequently seek to adjust their portfolios by moving assets from one mutual fund to another. This reallocation strategy often raises a question: can this be done without incurring a tax liability? The desire to rebalance holdings or pursue different investment objectives is common, but the tax implications are a concern. Understanding when and how taxes apply is part of making informed investment decisions.
Taxable Events in Brokerage Accounts
When you move money between mutual funds within a standard brokerage account, you are engaging in a taxable event. The Internal Revenue Service (IRS) views an exchange as two distinct transactions: the sale of shares in the first fund and the subsequent purchase of shares in the second. This sale is the moment a capital gain or loss is “realized” for tax purposes. Any profit from the sale must be reported on your tax return.
A common misconception is that exchanging funds within the same fund family is exempt from this rule. This is incorrect; the IRS treats this transaction identically to selling a fund from one company and buying one from another. The sale makes the gain or loss a reportable event regardless of where the proceeds are reinvested. Your brokerage firm will issue a Form 1099-B detailing these transactions, which you must use to report the capital gains or losses on Schedule D of your tax return.
The amount of tax you owe depends on how long you held the mutual fund shares. If you held the shares for one year or less, the profit is considered a short-term capital gain and is taxed at your ordinary income tax rate. If you held the shares for more than one year, the profit qualifies as a long-term capital gain, which is taxed at more favorable rates of 0%, 15%, or 20%, depending on your overall taxable income.
Exchanging Funds Within a Tax-Advantaged Account
The tax treatment of investment changes is different inside a tax-advantaged account. These accounts, such as 401(k)s, 403(b)s, Traditional IRAs, and Roth IRAs, are designed for retirement savings. Within these accounts, you can sell one mutual fund and buy another without creating an immediate taxable event. This allows investors to rebalance their portfolios without triggering capital gains taxes at the time of the exchange.
The growth within these accounts is tax-deferred, meaning you do not pay taxes on the gains year after year. For a Traditional IRA or 401(k), contributions are often made with pre-tax dollars, and the investments grow without being taxed. Taxes are only paid on the withdrawals you make during retirement, at which point the entire amount withdrawn is taxed as ordinary income.
With a Roth IRA or Roth 401(k), contributions are made with after-tax dollars. The investments still grow tax-free, and qualified withdrawals in retirement are also tax-free. This means that all the capital gains you accumulate from exchanging funds over the decades are never taxed.
The Inapplicability of Like-Kind Exchanges
Some investors may hear about a “like-kind exchange” and wonder if it applies to mutual funds. Governed by Section 1031 of the Internal Revenue Code, a like-kind exchange allows an individual to defer capital gains taxes when they sell an investment property and reinvest the proceeds into a similar property.
However, a major change implemented by the Tax Cuts and Jobs Act of 2017 significantly restricted the application of Section 1031. Effective January 1, 2018, like-kind exchange treatment is available only for exchanges of real property, such as trading one rental apartment building for another. The law explicitly excludes financial instruments from this provision. This means that assets like stocks, bonds, and mutual funds are not eligible for like-kind exchange treatment.
Therefore, you cannot sell a mutual fund and use the proceeds to buy another “like-kind” mutual fund to defer the tax bill. The rules are clear: the sale of a mutual fund in a taxable account is a reportable event, and any resulting gain is subject to capital gains tax in the year of the sale. Attempting to apply the Section 1031 rules to a portfolio of financial assets is a misinterpretation of current tax law.