How Tax Managed Funds Help Lower Your Tax Bill
Puttting you in control of the timing of gains
If you invest tax-efficiently you can reduce your tax bill and thus keep more of the investment returns you earn. One way to do that is to use a tax-managed mutual fund.
The effective use of tax-managed funds applies if you have a brokerage account, or invest in mutual funds, stocks, and bonds that are not inside a retirement account. (With your investments that are in a retirement account like an IRA or 401(k), all the gains are tax-deferred, so you don't have to think about taxes until you get to the point where you will be taking withdrawals.)
Tax-managed funds put you in control of when you incur taxes on gains because they deliver most of their capital gains in the form of unrealized gains. This means you don't pay taxes until you sell shares of the fund. Let's take a look at how this works.
Two Types of Capital Gains
- Capital Gains Upon the Sale of Shares of the Fund
When you sell shares of a mutual fund, if you sell them for more than you paid for them, you will realize either a short term or long term capital gain. For those of you in the 10 or 15% tax bracket, a zero percent capital gains tax rate applies to a certain amount of realized gains. Many have the opportunity to sell shares of their funds during a year where their tax rate is low, and thus pay absolutely no taxes at all on the gains!
- Embedded Gains That Are Distributed Each Year
Inside of the mutual fund, when the fund sells stocks or bonds that have a gain, that gain must be passed along to you as a shareholder of the fund. Even if you have all of your capital gains and dividends reinvested, you will still receive a 1099 form which shows the amount of the gain, and you will have to report the gain on your tax return and pay the applicable amount of tax. Most funds distribute these types of internal capital gains near the end of the year. This means with most mutual funds you will have some amount of capital gains to report each year even if you did not sell any shares of the fund.
Embedded Gains Can Unfairly Increase Your Tax Bill
This second type of gain is often referred to as an embedded capital gain because even if you have only owned the fund for a short while, you could end up receiving a capital gain distribution and having to pay tax. How does this happen? The mutual fund may have purchased a stock a long time ago; long before you were an owner of the fund. Now they sell it. Even though you have only owned the fund for a short time, you will participate in your proportional share of the capital gain on that stock.
Tax-Managed Funds Reduce Embedded Gain Distributions
A tax-managed mutual fund is managed to minimize capital gain distributions. Inside the fund, they work to harvest losses to offset gains - with the end result being you see your gains happen by watching the fund price increase (the first type of gain mentioned above), rather than by having a larger amount of annual capital gains distributions reported on a 1099 form. As you are in control of when you sell the shares, now you have more control over the tax year in which those gains are reported.
Tax-managed funds also attempt to reduce other forms of taxable distributions such as interest and dividend income. For example, a tax-managed balanced fund, which owns stocks and bonds, will often own municipal bonds, which generate interest that is free of federal income taxes.
Tax-managed funds put you in control of when you realize your capital gains. This is particularly important in retirement. You don't want a surprise tax bill, and a sudden increase in your taxable income can make more of your Social Security taxable.
In addition, as mentioned, for those in the 15 percent or lower tax brackets, there is a zero percent tax rate on long-term capital gains. By using a tax-managed fund, you can control when the gains occur by selling shares of the fund when you are in a tax year where the gain will not be taxed.
Used properly, tax-managed mutual funds can be a way to realize tax-free income in retirement.
Where to Find Tax-Efficient Funds
Many mutual funds companies offer funds that are designated as "tax-managed". For example, Vanguard offers a tax-managed balanced fund, international fund, small-cap fund, and more.
Even if you don't pick a tax-managed fund you can invest quite tax-efficiently by using index funds and index exchange-traded funds. iShares, for example, explains the importance of tax-efficiency in their Tax Strategies page.