One mistake newer investors make—and sometimes veteran investors—with mutual funds is that they forget to manage and minimize the costs of their funds. Minimizing expenses with mutual funds is no different than minimizing expenses when managing your finances. This is referred to sometimes as managing your cash flow.
Reducing your expenses (cash outflow) is just as beneficial as increasing your revenue (cash inflow). Similarly, minimizing taxes in a taxable account has the effect of decreasing your expenses, which increases your net returns.
You can think of this in another way: If you're paying more than necessary in taxes, you take home less money; therefore, you've reduced the return on your investment. Understanding how mutual funds are taxed, and becoming familiar with some actions you can take to minimize taxes is important if you have investments. Minimizing your taxes will help you get the most from your invested capital.
- You'll pay taxes on capital gains, dividends, and bond funds, and each are taxed in different ways.
- Fidelity, one of the larger investment management companies, has mutual funds that can keep taxes to a minimum in your taxable brokerage account.
- You can look at certain key statistics, such as the tax-cost ratio, to predict the tax-efficiency of a given fund.
How Your Mutual Funds Are Taxed
Anytime you earn money for something you haven't paid taxes on before, the government is going to want its share. One method of gathering taxes from investors receiving distributions is by enforcing the capital gains distributions tax.
Stock mutual funds may invest in 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.
Capital Gains Taxes
When the manager sells stocks that have gained in value since the time they purchased those stocks, the trades generate capital gains (money earned), which are then passed along to the investor in the form of capital gains distributions.
Capital gains are taxed differently than dividends, which are taxed as normal income—dividends are taxed at a higher rate. For this reason, distribution funds with low turnovers, such as index funds, can be more tax-efficient than actively-managed funds.
Mutual fund turnover occurs when managers sell shares in the fund and replace them with other shares.
Another common form of taxation coming from mutual funds is generated by dividends. Dividends are taxed as normal income unless it meets qualified dividend requirements (dividends from domestic corporations and qualified foreign corporations).
Therefore, if you want to minimize taxes, you'll want to avoid high yielding mutual funds, such as large-capacity (large-cap, or companies with large market capitalization) value stock funds. Fund types that pay little to zero dividends include small-cap stock funds and growth stock funds.
Bond Fund Taxes
Bond mutual funds are the type that you'll need to consider the most when it comes to minimizing taxes. To keep taxes to a minimum with bond funds, the best type to buy are municipal bond funds.
Municipal bonds are issued by state and local governments and other municipalities.
This type of mutual fund buys municipal bonds. 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
Fidelity, one of the larger investment management companies, has a number of mutual funds that can keep taxes to a minimum in your taxable brokerage account.
Lower fees and less turnover are other strategies you can use to reduce taxes.
Fidelity Small Cap Enhanced Index (FCPEX)
This index fund focuses on small-cap stocks, which generally pay fewer dividends when compared to large-cap stocks. For example, the average large-cap stock fund could have a yield of at least 2% 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% of other small-cap funds for tax-adjusted returns. The expense ratio is low for a small-cap fund at 0.64%, with no minimum initial investment.
Fidelity International Discovery Fund (FIGRX)
This 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 .78%, and there is no minimum initial investment.
Fidelity Tax-Free Bond (FTABX)
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 these.
The expense ratio is 0.25% 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 benefits.
Fidelity Tax-Exempt Money Market (FMOXX)
A money market fund can be a smart choice for investors wanting a liquid fundholding for short-term cash. Similar to the tax-free bond funds, FMOXX will be generally beneficial for investors in higher relative tax brackets.
FMOXX has an expense ratio of .45%, and there is no minimum initial investment.
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 the 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% and the tax-cost ratio was 1%, the investor's after-tax return would have been 9%.
Some online market and investing information websites, such as Morningstar, Inc., offer information on tax-cost ratios and other key indicators such as tax-adjusted returns. For example, at Morningstar.com, you can search for a mutual fund's ticker symbol and find information on the mutual fund you are researching.
Another way to minimize expenses is to purchase funds with no load (or no upfront expenses) with low expense ratios.
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 should be your first priority, then you should look at making it as tax efficient as possible.