Reducing taxes on your mutual funds is one of the best ways to save money while increasing your net investment returns, so a good tax strategy is an integral aspect of a good investment strategy. You have several options for reducing taxes on mutual funds.
Avoid Lump Sum Distributions
Taking a lump sum distribution is almost always a bad idea. You can avoid a big tax bill by doing a rollover instead if your mutual funds are held in a tax-deferred account, such as an IRA, 401(k), or tax-sheltered annuity. Or you can take your distributions in smaller quantities that are spread out over more than one calendar year.
You can avoid taxes altogether by transferring your 401(k) money over to another qualified plan, such as an IRA, if you have a 401(k) and don't need the money now. You can then take whatever amount you need from your IRA if you must withdraw money for any reason, rather than being taxed on the entire balance.
Be Smart About Asset Location
Asset location isn't the same as asset allocation. It is a strategy of selecting appropriate account types (finding the best location) for your investments. Taxation is significantly different in tax-deferred accounts from how is 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 might apply. And income from dividends isn't taxed in IRAs or 401(k)s until it's withdrawn at a later time, such as in retirement.
Funds that generate little to no income should be held in brokerage accounts. Those that might generate returns should be held in tax-deferred accounts. For example, you might consider using tax-efficient funds in a brokerage account, such as municipal bond funds, or funds that generate little or no dividend income, such as certain exchange-traded funds (ETFs), index funds, or growth stock funds.
Plan Ahead for Capital Gains Distributions
Mutual funds are required to distribute 95 percent of the net capital gains generated in their portfolios to their shareholders. Mutual fund companies generally post capital gain distribution estimates beginning in October to help shareholders prepare for this. These estimates can help mutual fund investors who own funds held in taxable accounts plan ahead for Tax Day.
Take Advantage of Tax Loss Harvesting
You'll have a capital gain if you sell your stock mutual fund for a higher price than what you paid for it. You'll have a capital loss if you sell your fund for a lower price than what you paid. You can use capital losses to offset capital gains or to reduce regular income through tax loss harvesting.
You might owe capital gains tax unless the investment is held in a tax-deferred account, such as an IRA or 401(k), if you generate a capital gain, but a capital loss can offset the capital gain. You can also use up to $3,000 to reduce your regular income after you've offset you're capital gain, or if you had no capital gains during the tax year.
An investor can carry forward any unused losses into future tax years when net losses exceed $3,000.
Tax loss harvesting is often a year-end investment strategy, but a wise investor should 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.
How Mutual Fund Dividends Are Taxed
Mutual fund shareholders can be taxed on a fund’s dividends, even if the distributions are received in cash or reinvested in additional shares. But dividends aren't taxable to an investor while they remain held in the account if it's a tax-deferred and tax-advantaged account, such as an IRA, 401(k) or an annuity.
An investor will pay income taxes on withdrawals during the taxable year in which the distribution or withdrawal is taken, if the investment is held in a taxable account.
Some mutual funds, such as municipal bond funds, pay income to shareholders that's exempt from federal taxation.
Mutual fund dividends are generally taxed as either ordinary income at the individual's income tax rate or as qualified dividends at lower capital gains tax rates.
Know the Timing of Dividend Dates
Dividends are only a concern for taxable accounts, such as individual and joint brokerage accounts, not for tax-deferred accounts, such as IRAs, 401(k)s, or tax-sheltered annuities.
You might end up receiving a dividend payment if you decide to add a mutual fund to your investment portfolio, especially at the end of a calendar year. This can be a welcome boost to your portfolio return, but you might not want the additional tax liability if you're not investing specifically for income. You might want to sell before the dividend date instead.
Pay attention to the ex-dividend date—the first day on which new buyers of a stock won't receive the dividend—if you want to avoid owing the tax on a dividend at the end of the year. This is usually two trading days before the dividend's record date, because stocks settle three days after the trade date.
Any owners of the stock on the day before the ex-dividend date will receive the dividend. This day is referred to as an "in-dividend date." For example, you would still receive the dividend if you were to sell tomorrow if the ex-dividend date were today, and you were to buy or sell your shares today.
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. The adjusted share price will tend to reflect this.
Use Tax-Efficient Funds
Tax-efficient funds generate little or no dividends or capital gains, so you'll want to find mutual fund types that match this style if you want to minimize taxes in a regular brokerage account. This is particularly the case if your investment objective is growth rather than income. You can eliminate the funds that are typically the least efficient and that generate the most taxes.
Mutual funds investing in large companies, such as large-cap stock funds, typically produce higher relative dividends because large companies frequently pass some of their profits on to investors in the form of dividends. Bond funds naturally produce income from interest received from the underlying bond holdings, so they're not tax-efficient either.
Use Funds With Low Turnover Ratio
One aspect of tax-efficiency is a low turnover ratio, which is expressed as a percentage of a particular fund's holdings that have been replaced or turned over during the previous year.
A low turnover ratio indicates a buy-and-hold strategy for actively managed mutual funds, but it's naturally inherent to passively managed funds like index funds ETFs. In general, a fund with higher relative turnover will have higher trading costs and higher tax costs than a fund with lower turnover.
Lower turnover generally correlates with higher net returns.
Analyze Tax-Cost Ratio
The tax cost ratio is a measurement of how taxes impact the net returns of an investment. For example, the tax cost ratio is 1 percent if your mutual fund earns a 10 percent return before taxes, but the tax costs incurred by the fund reduce the overall return to 9 percent.
Investors can find pre-tax returns, tax-adjusted returns, and tax cost ratios for mutual funds at Morningstar.
NOTE: The Balance does not provide tax, investment, or financial services or 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.