Mutual funds are some of the most popular investments around, yet many people have little idea of how their profits and earnings will be taxed—and thus how to avoid certain tax traps. You can’t control how well your mutual fund performs—you’ve handed that job over to the fund that picks the investments for you. But there are certain things you can do to minimize your taxes and thus maximize your earnings from a mutual fund.
You can make money from a mutual fund in two ways, each of which leads to different tax results:
This occurs when you sell your fund shares back to the fund and are no longer an investor in the mutual fund company. Any profit you earn from the sale will be either a short-term or long-term capital gain, depending on whether you owned the shares of the mutual fund for over one year.
Reinvesting your distributions won’t avoid tax. Mutual fund shareholders choose whether to receive their distributions in cash or have them reinvested in the fund through the purchase of new shares. Don’t base your choice on the tax consequences—the distributions will be subject to income tax either way. The only exception is if your mutual fund shares are held in a tax-deferred account like an IRA or 401(k).
Investors often purchase shares in the same mutual fund in separate lots over time. Each lot will typically have a different selling price, and therefore your shares will have a different basis, depending on when you bought them.
If you want to sell only part of your holdings of a mutual fund, always sell the shares with the highest basis (the ones you paid the most for) first. This will result in the smallest taxable profit for you (your profit is the selling price minus your basis). The same is true if you’re selling shares in a company.
The other way to make money from a mutual from is from the annual distributions the mutual fund sends you, representing your share of any profits, dividends, and interest the fund earned. Your tax rate on these distributions will depend on what kind of income the fund earned—ordinary income or short-term or long-term capital gains. This, in turn, will depend on what the fund invested in—stocks, bonds, tax-exempt bonds, and so on. You’ll be given this information each year, when the fund sends you IRS Form 1099-DIV. Many funds also issue their own tax reports and provide extensive information about taxes on their websites and in their literature—these can be a great resource.
Here's one tip: Don’t buy mutual funds just before year-end distributions. Mutual funds need to distribute 98% of their profits to their shareholders by the end of each year. For this reason, they often make large distributions of capital gains in December. If you invest in a mutual fund near the end of the year, you’ll have to pay tax on the distributions, even though you really don’t benefit from them, given that the fund’s share price will drop by the amount of the distribution. Most mutual funds have websites that can tell you when capital gain distributions are scheduled.
Some funds are more tax efficient than others—that is, they keep taxable distributions to a minimum. By investing in a tax-efficient mutual fund, you defer paying most of your taxes until you sell your shares. This doesn’t mean you shouldn’t invest in mutual funds that are not tax efficient. such funds—for example, those that invest in growth stocks—can be highly profitable. However, it’s best to place these funds in tax-deferred accounts such as IRAs, 401(k)s, and traditional IRAs. That way, you won’t have to pay any tax on the distributions the fund makes each year (so long as you leave them in your account). Of course, you must pay income tax at ordinary rates when you withdraw your earnings upon retirement.
So how do you know if a mutual fund is tax efficient? Some mutual funds, such as index funds, are inherently tax efficient because they are not actively managed; rather, their holdings simply mirror a stock index or some other criterion such as investing in specific industries or countries. The securities in these funds ordinarily don’t have to be traded very often.
Other funds are managed so as to keep distributions to a minimum. These funds sell shares as infrequently as possible and use other techniques to avoid having to distribute capital gains to their shareholders. Such funds often bill themselves as “tax managed.”
The Securities and Exchange Commission requires mutual funds to show their after-tax investment returns in their prospectuses. A mutual fund that claims to be tax efficient or tax managed must also show after-tax returns in its marketing literature and prospectuses. These should be easy to find on the mutual fund and broker websites.