Mutual funds can be a great way to invest because they have many advantages. However, mutual funds also have a lot of tax complications. Most investors aren’t aware of the associated tax issues when they first invest in mutual funds, but they’re important concerns.
If taxes are having a significant impact on your mutual fund returns, there are steps you can take to address tax issues.
Here are 7 ways to reduce taxes on your mutual fund investments:
Avoid purchasing shares before an ex-dividend distribution. Funds pay their capital gains distributions on a specific date.
- It doesn’t matter whether you owned the shares for 1 day or 10 years, you’re immediately going to be responsible for tax on the capital gains. This is true even you didn’t own shares in the fund when the gain was realized.
- Check and see when the fund makes its distributions. If it is happening soon, just wait until the date has passed.
- Most distributions happen towards the end of the calendar year. That is why the beginning of the year is a great time to purchase mutual funds.
Put your high-yield funds in tax-deferred accounts.
- All other things being equal, high-yield means high-tax.
- If possible, own these investments in tax-deferred accounts where the tax penalty will be minimized and your long-term gains will be the greatest.
Take a look at Exchange Traded Funds (ETFs) instead of mutual funds. ETFs usually have a lower tax consequence than actively managed mutual funds.
- These portfolios tend to be more stable since ETFs managers don’t have to sell securities to make capital gains distributions.
Consider funds that are more tax-efficient. There are mutual funds that are managed with the intention of minimizing the tax burden incurred by the investor.
- This is accomplished via municipal bonds, avoiding regular bonds, and utilizing any losses to offset any gains.
- Funds that specialize in municipal bonds can potentially avoid both state and federal taxes.
Choose a fund with a lower level of turnover.
- Funds that churn through many investments can create a tax burden on the investor, even if the fund’s share price drops.
- It is almost always true that a fund with fewer turnovers in its investments will result in less tax burden and is also a sign that a fund has a long-term approach to investing.
Take full advantage of IRA, 401(k), and other tax-deferred investment accounts.
- Your investments will grow at a much greater rate if you can refrain from pulling money out of them to pay taxes. True, you will have to pay the tax someday, but your nest egg will grow much larger in these accounts.
- Anytime you consider selling shares in a fund, consider the tax implication. It would be best if you have the resources available to pay the taxes without having to dip into other investments.
- Make certain you have the money set-aside and available when tax time arrives.
- Remember that investments held for a minimum of a year are taxed at a lower rate than investments held for less than a year.
There are many ways to minimize the taxes realized with mutual fund ownership. However, taxes are not the only consideration. Sometimes it is best to sell and lock in your profits rather than hold on to an investment for tax purposes. Always let common sense be your guide.