Mutual funds can be an excellent investment method 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 essential concerns.
If taxes significantly impact your mutual fund returns, you can take steps to address tax issues.
Here are seven 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.
- Whether you owned the shares for one day or ten years doesn’t matter. You’re immediately going to be responsible for tax on the capital gains. This is true even if 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, wait until the date has passed.
- Most distributions happen toward 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.
- 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 ETF managers don’t have to sell securities to make capital gains distributions.
Consider more tax-efficient funds. There are mutual funds that are managed to minimize the tax burden incurred by the investor.
- This is accomplished via municipal bonds, avoiding common bonds, and utilizing losses to offset gains.
- Funds specializing in municipal bonds can potentially avoid 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 a sign that a fund has a long-term investment approach.
Take full advantage of IRA, 401(k), and other tax-deferred investment accounts.
- Your investments will grow much more if you can refrain from pulling money out of them to pay taxes. You will have to pay the tax someday, but your nest egg will grow much more significant in these accounts.
- Anytime you consider selling shares in a fund, consider the tax implication. It would be best to have the resources available to pay the taxes without dumping them into other investments.
- Ensure 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.