Taxes can be complicated, and for investors in mutual funds, they can be very complicated. Dividends and income may be taxed if you own mutual fund shares, and capital gains taxes may be imposed if you sell mutual fund shares. You don’t even have a say in realizing any profits from the fund’s holdings, as that decision is made by the fund manager on behalf of all shareholders.
But it’s actually pretty easy to understand once you break things down into the different types of taxes. Here are the top mutual fund taxes to be aware of and some strategies to minimize them.
Mutual fund tax
Mutual funds can be a good option for investors because they allow you to hold a diversified portfolio of securities with relatively small investments. However, investing in mutual funds means that you have no control over your individual holdings in the fund, which is at the discretion of the fund manager. The price or net asset value (NAV) of the fund will rise and fall based on the performance of the fund’s underlying holdings.
Dividends and Interest: If the Fund holds securities that pay dividends or interest, the Fund will pay you your share of those payments and you will owe tax on that income. Some mutual funds, such as the B. Municipal Pension Fund, focus on investments that are exempt from federal income tax. If you receive dividends or interest from a fund you hold, you may receive an IRS tax return showing your income from the fund for the year. The form can come from the fund house itself or from your online broker.
Capital gains: Fund managers can sell securities in the fund for a profit, which triggers a capital gains tax. The tax impact depends on how long the fund holds the shares sold. Capital gains are usually distributed annually to unitholders who pay tax on the gains.
Even if you’re still the owner, you can trigger fund taxes on mutual fund shares in two ways:
Mutual Fund Taxes When Selling Stocks
If the securities held in your mutual fund perform well, the fund’s NAV will increase, allowing you to make a profit on your initial purchase. You have to pay tax on that gain, but figuring out exactly how much you owe can be complicated.
The calculation is relatively easy if you buy all the stocks at once. You subtract the price you paid per share from the price you sold, and the difference is your earnings per share. But over time, most people buy mutual funds on a regular basis, which means you’ve paid several different prices for the stock. You can use the average cost of all the stocks you own to calculate your profit, or you can use specific stocks with a specific cost basis.
How long you hold the stock is also important. If you hold the stock for more than a year, you may be eligible for a capital gains tax deduction because the gains are considered long-term. You will be taxed at ordinary income tax rates on gains on stocks held for less than a year.
How to Minimize Mutual Fund Taxes
Mutual fund taxes are a sign that you’re getting some form of investment income or realized profits, so they’re not all bad. But tax avoidance can help you earn higher returns in the long run. Here are some of the best ways to reduce taxes on mutual fund investments:
- Holding shares in a tax-advantaged account: One of the easiest ways to avoid taxes on mutual fund investments is to hold shares in a tax-advantaged account, such as a 401(k) or a traditional or Roth IRA. Your investments can grow tax-free, which means you don’t pay tax on distributions received or profits earned. In the case of a Roth IRA, you also don’t pay tax on withdrawals.
- Holding money for the long term: Holding money for more than a year can get you taxed at the long-term tax rate on capital gains, which is a huge benefit for most investors.
- Avoid certain types of funds: If you want to avoid taxes, you should probably stay away from dividend-focused funds or funds with high portfolio turnover, both of which can generate substantial realized gains. Index funds are probably your best bet because they typically pay modest dividends and have low turnover.
- Tax Loss Harvest: Employing a tax loss harvest strategy involves selling some investments at a loss to recoup your gains, thereby reducing the amount of tax you pay.
You can also limit your tax exposure by holding exchange-traded funds (ETFs) instead of mutual funds. ETFs typically hold similar investments as their mutual fund counterparts, but are not required to distribute realized capital gains, making them more tax efficient.
Bottom line
Mutual fund taxes can be complicated because you can tax dividends and fund profits even before you sell the stock. Of course, if you decide to sell, you will also be taxed on any appreciation in the fund. The easiest way to avoid this is to have mutual funds in tax-advantaged retirement accounts like IRAs and 401(k). You also ensure that you hold the investment for the long term, so if you owe taxes, you can pay it at a lower rate of return on your long-term capital.
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