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 the tax issues. Here's how you can reduce taxes on mutual fund investments.
1Buy Shares At The Right Time
Funds pay their capital gains distributions on a specific date. It doesn't matter whether you owned the shares for one day or ten years - you're immediately going to be responsible for tax on the capital gains. It's 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.
2Put Your Funds In Tax-Deferred Accounts
Consider putting your high-yield funds in tax-deferred accounts. Like 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 where your long-term gains will be the greatest.
3Consider Exchange-Traded Funds (ETFs)
ETFs usually have a lower tax consequence than actively managed mutual funds. Also, these portfolios tend to be more stable. ETFs managers don't have to sell securities to make capital gains distributions.
4Keep Tax-Efficient Funds
There are mutual funds 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.
5Choose Funds With Lower Turnover Level
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. It is also a sign that a fund has a long-term approach to investing.
6Have 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 still have to pay the tax someday. But your nest egg will grow much larger in these accounts.
7Always Plan Ahead
Are you considering selling shares in a fund? Anytime you do, 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 that 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.