How to Reduce Taxes on Mutual Funds
Best Investment Strategies to Minimize Taxation
Reducing taxes on your mutual funds is one of the best ways to save money while increasing your net investment returns. Therefore, a good tax strategy is an integral aspect of a good investment strategy. In this article, we'll show you some of the best ways to reduce taxes on mutual funds.
Avoid Lump Sum Distributions
Taking a lump sum distribution is almost always a bad idea. If your mutual funds are held in a tax-deferred account, such as an IRA, 401(k), or Tax-Sheltered Annuity, you can avoid a big tax bill by doing a rollover or by taking your distributions in smaller quantities, spread over more than one calendar year.
If you have a 401(k) and don't need the money now, you are wise to avoid taxes altogether by transferring your 401(k) money over to another qualified plan, such as an IRA. If you need to withdraw money for any reason, you can then just take whatever amount you need from your IRA, rather than being taxed on the entire balance, as in the case of a lump sum distribution from a 401(k).
Be Smart About Asset Location
Not to be confused with asset allocation, asset location is a strategy of selecting appropriate account types (finding the best location) for your investments. Taxation is significantly different in tax-deferred accounts than in brokerage accounts.
Selling mutual funds in a tax-deferred account, such as an IRA or 401(k), will not generate capital gains taxes. In fact, selling funds generates no taxes at all (although other mutual fund fees may apply). Also, income from dividends is not taxed in IRAs or 401(k)s until withdrawn at a later time, such as retirement.
Funds that generate little to no taxes should be held in brokerage accounts and mutual funds that may generate taxes should be held in tax-deferred accounts. For example, in a brokerage account, you might consider using tax-efficient funds, such as municipal bond funds or funds that generate little or no dividend income, such as certain Exchange Traded Funds (ETF), Index funds or growth stock funds.
Plan Ahead for Your Capital Gains Distributions
Mutual funds are required to distribute 95% of the net capital gains generated in their portfolios to their shareholders. To help shareholders prepare for capital gain distributions, mutual fund companies generally post capital gain distribution estimates beginning in October. These capital gain distribution estimates can help mutual fund investors (who own funds held in taxable accounts) plan ahead for tax day.
Know How and When to Take Advantage of Tax Loss Harvesting
If you sell your stock mutual fund for a higher price than you bought it, you will have a capital gain. If you sell your fund for a lower price than you bought it, you have a capital loss. When you use capital losses to offset capital gains or to reduce regular income, you are doing something called tax loss harvesting.
When you generate a capital gain, you may owe capital gains tax (unless the investment is held in a tax-deferred account, such as an IRA or 401(k)). However, a capital loss can either offset the capital gain or, if there were no capital gains during the tax year, you could use up to $3,000 to reduce your regular income. If net losses exceed $3,000 an investor can carry forward any unused losses into future tax years.
Tax loss harvesting is often a year-end investment strategy but a wise investor will be mindful of all fund purchases and sales throughout the year and make investment decisions based upon investment objectives, not the whims of the market.
Learn How Mutual Fund Dividends Are Taxed
It is important to note first that mutual fund shareholders can be taxed on a fund’s dividends, even if these distributions are received in cash or reinvested in additional shares of the fund. Also, for certain tax-deferred and tax-advantaged accounts, such as an IRA, 401(k) or annuity, dividends are not taxable to the investor while held in the account. Instead, the investor will pay income taxes on withdrawals during the taxable year the distribution (withdrawal) is made. Some mutual funds, such as Municipal Bond Funds may pay income to shareholders that are exempt from federal taxation.
For taxable accounts, such as individual and joint brokerage accounts, mutual fund dividends are generally taxed either as ordinary income (taxed at the individual's income tax rate) or as qualified dividends (taxable up to a 15% maximum rate). Ordinary and qualified dividends are reported to mutual fund investors on the tax Form 1099-DIV. For tax filing purposes, the mutual investor (taxpayer) will report dividends on Form 1040, Schedule B, and Form 1040, lines 9a and 9b.
Know the Timing of Dividend Dates
Again, in terms of taxation, dividends are a concern only for taxable accounts, such as individual and joint brokerage accounts (not tax-deferred accounts, such as IRAs, 401(k)s or Tax-sheltered annuities). If you decide to add a mutual fund to your investment portfolio, especially at the end of a calendar year, you may end up receiving a dividend payment. This can be a welcome boost to your portfolio return but if you are not investing specifically for income, you may not want the additional tax. Similarly, if you are thinking of selling shares of a mutual fund, you may want to sell it before the dividend date to avoid the tax.
To avoid the tax on a dividend at the end of a year, pay attention to the Ex-Dividend Date, which is the first day in which new buyers of a stock will not receive the dividend. This day is usually two trading days before the dividend's Record Date because stocks settle three days after the trade date (referred to as a 'T + 3' settlement period for 'Trade date plus three').
For greater understanding, any owners of the stock on the day before the Ex-Dividend Date will receive the dividend. This day prior to Ex-Dividend is referred to as an In-Dividend date. For example, if the Ex-Dividend Date was today and you bought or sold your shares today, you would still receive the dividend even if you sold it tomorrow.
Note: A stock's share price usually decreases on the Ex-Dividend date by an amount roughly equal to the dividend paid because a dividend is a decrease in the company's assets and the adjusted share price will reflect this.
Use Tax-Efficient Funds
Tax-efficient funds generate little or no dividends or capital gains. Therefore, you will want to find mutual fund types that match this style if you want to minimize taxes in a regular brokerage account (and if your investment objective is growth - not income). First, you can eliminate the funds that are typically least efficient (generate most taxes).
Mutual funds investing in large companies, such as large-cap stock funds, especially in the large-value category, typically produce higher relative dividends because large companies often pass some of their profits along to investors in the form of dividends. Bond funds naturally produce income from interest received from the underlying bond holdings, so they are not tax-efficient either.
You also need to be cautious of actively-managed mutual funds because they are trying to "beat the market" by buying and selling stocks or bonds. So they can generate excessive capital gains compared to passively-managed funds.
Use Funds With Low Turnover Ratio
One aspect of tax-efficiency is the low turnover ratio, which is expressed as a percentage of a particular fund's holdings that have been replaced (turned over) during the previous year. A low turnover ratio indicates a buy and hold strategy for actively-managed mutual funds but it is naturally inherent to passively-managed funds, such as index funds and Exchange Traded Funds (ETFs). In general, and all other things being equal, a fund with higher relative turnover will have higher trading costs (Expense Ratio) and higher tax costs, than a fund with lower turnover. In summary, lower turnover generally translates into higher net returns.
Analyze Tax-Cost Ratio
Just as it sounds, the tax cost ratio is a measurement of how taxes impact the net returns of an investment. For example, if your mutual fund earns a 10% return before taxes but the tax costs incurred by the fund reduce the overall return to 9% the tax cost ratio is 1%. Investors can find pre-tax returns, tax-adjusted returns, and tax cost ratio for mutual funds at Morningstar.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.