Top 9 Things to Know About Mutual Fund Taxation
Strategies and Examples to Reduce Taxes and Maximize Returns
Understanding mutual fund taxation can help you improve your total portfolio return by reducing or eliminating taxes on your funds. Learning which types of funds are best for taxable accounts (and which ones to avoid) can help you to maximize returns while minimizing unwanted taxes.
One of the biggest mistakes investors make is placing mutual funds that generate high relative taxes in their taxable accounts. For example, most bond funds and dividend-paying stock funds generate income that's taxable to the investor. These funds are therefore best purchased in a tax-deferred account, such as an IRA, 401(k), or annuity. You'll avoid needless income tax.
Invest in mutual funds that generate little to no taxes if you have a taxable account, such a regular individual or joint brokerage account. These funds are considered tax-efficient. For example, you might consider using municipal bond funds, which generate income generally tax-free at the federal level, if you need exposure to bonds.
Be sure to avoid funds that pay generous dividends. They'll generate more taxes than those that pay little or no dividends.
How Mutual Fund Dividends Are Taxed
Some companies pass along their profits to stock shareholders in the form of dividends. A mutual fund investing in stocks might therefore receive dividends from the companies in which it invests, then pass along dividends to the mutual fund shareholder.
A mutual fund investor often chooses to have dividends reinvested into the fund, but they might still owe taxes. The amount of taxes owed will depend upon the holding period and your income tax bracket, among other factors.
Mutual Fund Capital Gains Distributions
Mutual funds might invest in dozens or hundreds of stocks. Often the mutual fund manager will buy and sell shares of several of stocks in the mutual fund during any given year. These trades can generate capital gains, which are then passed along to the investor (you) when the manager sells stocks that have gained in value since the time they purchased them.
Plan Ahead for Distributions
Mutual fund companies generally post capital gain distribution estimates beginning in October to help shareholders prepare for them. These capital gain distribution estimates can help mutual fund investors who own funds held in taxable accounts to plan ahead for tax day.
Tax Loss Harvesting
Many investors make the mistake of paying capital gains taxes when they could have reduced or eliminated them by offsetting the gains with capital losses.
For example, imagine you want to rebalance your portfolio so you decide to sell shares of two funds. Generally, equal gains and losses would offset each other and no tax would be owed if you have $1,000 of capital gains as a result of selling the first fund, and $1,000 of capital loses as a result of selling shares of the other fund.
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 would be 1% if your mutual fund earns a 10% return before taxes, but the tax costs incurred by the fund reduce the overall return to 9%. Investors can find pre-tax returns, tax-adjusted returns, and tax cost ratio for their mutual funds at Morningstar.
Index Funds vs. Actively Managed Funds
Funds that try to "beat the market" are referred to as actively managed funds. Those that simply try to match the returns of the market or a given benchmark are passively managed funds.
Actively managed funds typically have higher turnover. They buy and sell more stocks or bonds, and they therefore have higher tax costs than index funds and exchange-traded funds (ETFs). You might want to consider using one of the best S&P 500 Index Funds for tax efficiency.
How to Choose the Best Mutual Funds
The best performing mutual funds over long periods of time, such as 10 years or more, are often the funds with the lowest tax costs. An investor looking for looking for the best-performing funds will likely find the most tax-efficient funds, even if they're not trying, simply because there's a high correlation between low tax costs, low turnover ratio, and low expense ratios to high relative returns, especially for longer investment periods.
The Bottom Line
Taxes can be minimized or even avoided by choosing tax-efficient funds for your taxable accounts. These funds include growth stock funds, index funds, and municipal bond funds. You should be able to increase your overall investment portfolio returns with knowledge of the basics on mutual fund taxation.
Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as tax advice or investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.