Mutual funds and tax efficiency don't usually go hand in hand, but there are ways to keep the taxes your mutual funds generate to a minimum.
Most mutual funds, by their very nature, trigger taxable events. Fund managers buy and sell securities in order to produce what they believe will be the best possible returns - often without considering the tax implications of their trading. And note that mutual funds usually report their performance using pretax returns, which can be as much as 15% more than after-tax returns.
Capital gains distributions
Profits realized by funds are aggregated throughout the year, and any gains - minus losses - are distributed to shareholders, usually at the end of the year. Even if you did not sell any of your shares in a fund, you must still pay taxes on any capital gains produced when the manager sold appreciated shares.
When a fund sells securities and realizes capital gains, it distributes the gains to shareholders - usually in a one-time distribution at the end of the year. Depending on how long the fund owned the security - less than a year or more than a year - the gain will be taxed at the taxpayer's highest ordinary income tax rate or the current federal long-term capital gain tax rate.
Funds don't necessarily distribute capital gains if they had negative total returns for the year, although they can do so, depending on how the fund is managed.
If you invested in a fund late in the year, you may still have to pay taxes on gains you didn't get. When you sell the fund shares, you may also have to pay capital gains taxes if your fund shares were held in a taxable account.
Mutual funds must also distribute any income they earn from stocks or bonds. Investors are responsible for paying taxes on dividends and interest from the securities held in their funds.
The income is taxed according to each investor's federal income tax rate. The higher your tax bracket, the more you will pay in taxes on earned income from your funds.
How to minimize your mutual fund taxes
There are ways to keep your mutual fund taxes down - and it is likely in your best interest to do so.
For starters, put funds that frequently make distributions into tax-deferred accounts, such as an IRA or 401(k). Then search for funds with low turnover rates. The less a fund trades, the lower your taxes will be. You may want to consider index funds for this reason. Index funds are mutual funds that are not actively managed but pegged to stock indexes. They rarely trade securities and are generally known for excellent tax efficiency.
Many mutual fund companies are now offering tax-managed funds that use various strategies to minimize distributions. Tax-managed funds take tax considerations into account in all trading decisions - avoiding short-term gains and stocks that pay dividends. If taxes are a primary concern, you may want to avoid income-generating funds, such as bond funds. However, municipal bond funds are almost always tax-exempt.
It is important for mutual fund investors to be vigilant about taxes - but not at the expense of superior performance. When choosing a fund, simply compare returns on an after-tax basis and select whichever funds have the highest performance, regardless of their tax efficiency.
Updated: January 1, 2013
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.
© 2013 Wilmington Trust Corporation.