How Tax-Managed Funds Help Lower Your Tax Bill

A woman on a laptop doing her taxes
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Taxes have a way of eating away at your investments. But, if you invest tax-efficiently, you can reduce your tax bill and thus keep more of the investment returns you earn.

Tax-deferred retirement accounts such as a 401(k) or IRA are inherently tax efficient since you won't pay taxes until you begin to withdraw funds in retirement. However, if you have a brokerage account or invest in mutual funds, stocks, and bonds that are not inside a retirement account, you could be on the hook for a major tax bill. That's where tax-managed funds come in.

What Are Tax-Managed Funds?

Tax-managed funds are specifically designed to reduce taxes on your investments. They do this in a number of ways, whether by avoiding dividend-paying stocks, selling some stocks at a loss to offset other gains, or holding on to stocks rather than selling.

Many investors aren't aware of the significant impact taxes can have on their gains. According to Morningstar, these eat up 2% of your gains on average. That means an 8% gain is really a 6% gain after you've paid taxes on it. Tax-advantaged funds are structured to reduce that effect.

Two Types of Capital Gains

To understand what kind of taxes you could face on your investments, it's important to realize two types of capital gains that can trigger taxes for you.

Capital Gains Upon the Sale of Shares of the Fund

Normally, when you sell shares of a mutual fund, you will be taxed on any gains your shares made while you owned them. When you sell shares of a mutual fund for more than you paid for them, you will realize either a short-term or long-term capital gain.

If you held the asset for longer than 12 months, it's considered a long-term capital gain. Otherwise, it's considered short-term and taxed as ordinary income.

Below certain income levels, a 0% capital gains tax rate applies to a certain amount of realized long-term gains. This means that many taxpayers 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. At higher income thresholds, you'll pay 15% or 20% on these long-term gains.

The following chart shows how these taxes apply at different income levels:

2021 Capital Gains Tax Rates and Income Levels
 Capital Gains Tax Single Filer Income Level Married Filing Jointly Income Level Head of Household Income Level 
 0%  $0  $0  $0
15%   $40,400  $80,800  $54,100
 20%  $445,850  $501,600  $473,750
Source: The Tax Foundation

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 that 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 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. If the fund happens to sell that stock right after you buy shares, you're on the hook for the gains—and the taxes. 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.

How Tax-Managed Funds Reduce Embedded Gain Distributions

A tax-managed mutual fund is set up to minimize capital gain distributions. Inside the fund, managers work to harvest losses to offset gains. The end result is that you see your gains happen by watching the fund price increase (the first type of gain mentioned above), rather than through a larger amount of annual capital gains distributions. Since 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 benefits taxable.

In addition, as mentioned, for those in the lower tax brackets, there is a 0% 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 fund 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. Both of these options offer great ways to reduce your tax obligation and keep more of your returns.