Best Fidelity Funds to Keep Taxes Low
These Fidelity Mutual Funds Can Minimize Your Tax Bill
Investors with taxable brokerage accounts are smart to hold tax-efficient mutual funds and there are plenty of outstanding Fidelity funds to choose from to get the job done.
One of the biggest mistakes investors make with mutual funds is failing to keep costs low. Minimizing expenses with mutual funds is no different than minimizing expenses in personal or business finance, specifically with budgeting, or what some financial experts might call cash flow.
Reducing your expenses (cash outflow) is just as good as increasing your revenue (cash inflow). Cutting costs in personal finance is just as good as giving yourself a raise.
Similarly, minimizing taxes in a taxable account has the effect of increasing your net returns. Think of this in the opposite way: If you're paying more than necessary in taxes, you keep less money to yourself; therefore you've reduced the return on your investment.
Best Types of Mutual Funds for Reducing Your Tax Bill
One form of tax that is common with mutual funds is capital gains distributions. Stock mutual funds may invest in dozens or hundreds of stocks. During any given tax year, the manager(s) of the fund will typically buy and sell several of the stock holdings in the portfolio. When the manager sells stocks that have gained in value since the time he or she purchased those stocks, these trades generate capital gains, which are then passed along to the investor (you) in the form of capital gains distributions. For this reason, funds with low turnover, such as index funds, can be more tax-efficient than actively-managed funds.
Another common form of taxation coming from mutual funds is generated by dividends. Therefore, if you want to minimize taxes, you'll want to avoid high yielding mutual funds, such as large-cap value stock funds. Fund types that kick off little to zero dividends include small-cap stock funds and growth stock funds.
We've covered stock fund types that are tax efficient but bond mutual funds are the ones that you'll need to smart about when it comes to minimizing taxes. To keep taxes to a minimum with bond funds, the best type to buy are municipal bond funds. This type of mutual fund buys municipal bonds, which are issued by a state and local governments and other municipalities. To incentivize government investment, municipal bonds are free of federal income tax. If you live within the state or municipality that issues the bond, income may also be tax-free on that level.
Best Fidelity Funds to Minimize Taxes
Now let's take a look at some specific examples of mutual funds from Fidelity that can keep taxes to a minimum in your taxable brokerage account.
- Fidelity Total Market Index (FSTMX) is not the most tax-efficient Fidelity fund you can buy but it may be the most diversified stock mutual fund in their lineup that can also keep taxes to a minimum. Its low turnover ratio of just 3 percent means that it will keep taxes on capital gains distributions much lower than the average stock fund.The expense ratio for FSTMX is a rock bottom 0.095 and the minimum initial purchase is $2,500.
- Fidelity Small Cap Enhanced Index (FCPEX) focuses on small-cap stocks, which generally kick off less dividends compared to large-cap stocks. For example, the average large-cap stock fund could have a yield of at least 2 percent or more, whereas FCPEX will typically average less than half that. Low yields will help keep income taxes to a minimum. FCEPX has historically beaten more than 90 percent of other small-cap funds for tax-adjusted returns. The expense ratio is low for a small-cap fund at 0.68 percent and the minimum initial investment amount is $2,500.
- Fidelity International Capital Appreciation (FIGRX) is a foreign stock fund that primarily invests in stocks of non-U.S. companies. Foreign stock funds are not commonly tax-efficient but FIGRX has a track record of better than average tax-efficiency and above-average returns, which combines to make FIGRX a smart choice for investors needing a foreign stock fund in a taxable account. The expense ratio for FIGRX is below-average at 1 percent and the minimum initial investment is $2,500.
- Fidelity Tax-Free Bond (FTABX) holds municipal bonds that are exempt from federal income tax. Most of the holdings are bonds issued by state and city governments in the United States. Municipal bonds often offer lower yields than other bonds but the tax-free status can produce a tax-effective yield that can beat other bonds. Generally, investors who are in higher tax brackets benefit the most from holding municipal bond funds like FTABX. The expense ratio is 0.25 percent and the minimum initial investment is $25,000. Fidelity also offers tax-free municipal bond funds that focus on states, such as California, New York and Massachusetts. Investors living within these states may choose to use these funds to take advantage of state tax benefit.
- Fidelity Tax-Exempt Money Market (FMOXX) can be a smart choice for investors wanting a liquid fund holding for short-term cash. Like the tax-free bond funds, FMOXX will be generally beneficial for investors in higher relative tax brackets.
What to Look for to Find Your Own Tax-Efficient Funds
If there are other fund types you need for your taxable account, you can look at certain key statistics to predict the tax-efficiency of the fund. One such statistic is tax-cost ratio, which is a measure of how much investors lost on average due to taxes. For example, if a mutual fund had a 5-year annualized return of 10 percent and the tax-cost ratio was 1 percent, the investor's after-tax return would have been 9 percent.
Some of the best online mutual fund research websites, such as Morningstar, Inc., offer information on tax-cost ratio and other key data points like tax-adjusted returns. For example, at Morningstar.com, you can simply type in a mutual fund's ticker symbol and do a search for a particular mutual fund you are researching. Once you find the fund's listing on the site, look for the tab that says "Tax" and click on it. That page will display key tax data points, such as tax-cost ratio and tax-adjusted returns. You can compare these with other funds and choose the one that is best for you and your investing needs.
Above all, investors should remember to prioritize smart investing practices, such as diversification, risk tolerance, and fund selection based upon investment objectives, not just tax-efficiency alone. Building a portfolio suited for your needs is more important than minimizing taxes. Investors can also reduce costs by buying no-load funds with low expense ratios.
Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.