Tax Implications of a Unit Investment Trust

Investments made through various investing vehicles have different tax implications, such as fixed-income investment versus equity investment, or investment through a mutual fund versus through a unit investment trust. Even though tax may not be your top investment consideration, failure to take into account potential tax effects will directly reduce current investment returns and potentially weaken long-term investment results. While each year's tax savings adds to the current bottom line, the compounding effect of having tax savings invested contributes more to future investment returns over a long period of time.

In general, using a unit investment trust as an investment vehicle has certain positive tax implications. A unit investment trust is sponsored by professional investment managers and sold to individual investors. Trust managers are responsible for selecting a portfolio of diversified securities. Once investments are made, a unit investment trust adopts the passive investment strategy of buy and hold, which is required by law. Unlike mutual funds that constantly buy and sell their portfolio holdings, incurring realized capital gains along the way, a unit investment trust can avoid such capital gains tax as it basically has no investment turnovers.

Unrealized capital gains from security appreciation may be calculated differently due to different rules on determining an investment's cost basis. For mutual fund investors, regardless of an individual investors' own fund purchase price, the fund value at the beginning of a year is used as the cost basis for deciding any unrealized capital gains that the fund may have accumulated during the year, which could potentially inflate capital gains for investors who have a higher individual cost basis. With a unit investment trust, each investor's unit purchase is recognized as his own cost basis to calculate any accumulated capital gains over time.

Unlike capital gains, interest income is taxed at the highest tax rate as ordinary income. However, investors who have low-risk tolerance would rather invest in income-generating, bond-like securities despite the higher taxes. Other investors can potentially avoid any interest income and its tax effect by investing in equity mutual funds, given that a fund does not hold any interest-earning cash equivalents. But unit investment trusts are required to hold 5 percent of the total investment value in cash, which likely earns interest income when temporally put into short-term marketable securities.

Unlike mutual fund investors, who may purchase and redeem fund shares frequently, unit investment trust investors intend to hold their unit shares through the trust term. The law requires that all unit investment trusts have a definite life and be terminated at the end of the term. Moreover, the unmanaged passive investment style is best served by a specified, predetermined investment horizon so investments can move from one type to another to chase better returns. Any capital gains taxes are due when investors receive investment proceeds upon trust termination. Although the nature of unit investment trusts forces investors to roll over their investments eventually, the delay of tax on capital gains should have worked to investors' advantage.