For a long time, mutual funds have been a popular investment vehicle for millions of investors, largely because they offer an easy way to purchase no-fuss, diversified assets with relative ease.
This out-of-the-box diversification and risk-mitigation is something that individual stocks can’t match.
Though technology has made it easier than ever to buy securities like mutual funds online, one area of confusion persists. When it comes to tax on mutual funds, and calculating capital gains on mutual funds, many investors don’t know where to start.
Discussing tax on mutual funds and other investments can be tricky, but it doesn’t have to be. Read on to learn how tax on mutual funds works, what investors should expect or anticipate when it comes to dealing with mutual funds and the IRS, and some simple strategies for tax-efficient investing.
Quick Mutual Fund Overview
First, it makes sense to review the basics. Mutual funds are similar to exchange-traded funds (ETFs) in that they’re not singular investments. Instead, they’re a collection (or a “basket”) of many different investments like stocks, bonds and short-term debt. When an investor buys into a mutual fund, they’re essentially purchasing a spectrum of assets all at once.
Paying Tax on Mutual Funds
Like other types of investments, investors must pay tax on any income or profits they realize from their mutual fund holdings. Not every fund is the same, so it follows that the taxable income shareholders receive (or don’t receive) from a fund isn’t the same.
Since it’s up to investors to know when to pay taxes on stocks and report the amount of taxable income they’ve received from the sales of their investments and distributions (on IRS Form 1099-DIV) the most proactive thing an investor can do to get an idea of what type of tax liability a specific mutual fund may present is to research the fund before any shares are purchased. In other words, do your homework.
There are a number of online resources — including but not limited to Morningstar and Kiplinger Mutual Fund Finder — that allow investors to conduct that research, with some also providing rating systems to help streamline the process.
Paying Tax on ‘Realized Gains’ from a Mutual Fund
It may come as a surprise that shareholders may owe taxes on their mutual fund holdings even if they don’t sell them. That’s because shareholders are still generating income from those holdings, which is often called “realized” gain.
Mutual funds are actively managed, meaning that an individual or company is regularly making decisions about what the fund contains by buying and selling investments, a process that can net profits. Those profits, or gains, are then passed back to shareholders as distributions (or as dividends) or reinvested in the fund.
When shareholders are awarded distributions from funds, they’re seeing a “realized” gain from their investment. For that reason, shareholders may end up owing tax on investments that they have not sold, or even that may have lost value over the year.
Paying Capital Gains on Mutual Funds
Most investors likely know that when they sell shares of a mutual fund, they’ll need to pay taxes on the earnings. Specifically, they’ll pay capital gains tax, which is a tax on the profit made from selling an investment. Depending on how long an investor held the investment (short-term versus long-term), the capital gains taxation rate will vary.
Because funds contain investments that may be sold during the year, thereby netting capital gains, investors may be on the hook for capital gains taxes on their mutual fund distributions. As each fund is different, so are the taxes associated with their distributions.
So reading through the fund’s prospectus and any other available documentation can help investors figure out what, if anything, they owe.
How to Minimize Taxes on Mutual Funds
When it comes to mutual funds, taxes are going to be a part of the equation for investors — there’s no way around it. But that doesn’t mean that investors can’t make some smart moves to minimize what they owe. Here are a handful of ways to potentially lower taxable income associated with mutual funds.
1. Know the Details Before You Invest
Do your homework! The holdings in each fund, and the way they’re managed, will ultimately play a big role in the tax liabilities associated with each fund. Before investing in a specific mutual fund, it’s worth digging through the prospectus and other documents to get a sense of what to expect.
For example, an investor can typically find out ahead of time if a mutual fund makes capital gains distributions, or how often a fund pays out dividends. Those are the types of income-generating events that will need to be declared to the IRS come tax time.
Some investors might choose to look for tax-efficient funds that are specifically designed to help mutual fund investors avoid taxes.
2. Use a Tax-deferred Account
Some brokerage or investment accounts — including retirement accounts like IRAs and 401(k)s — are tax-deferred. That means that they grow tax-free until the money contained in them is withdrawn. In the short-term, using these types of accounts to invest in mutual funds can help investors avoid any immediate tax liabilities that those mutual funds impose.
3. Hang Onto Your Funds to Avoid Short-term Capital Gains
If the goal is to minimize an investor’s tax liability, avoiding short-term capital gains tax is important. That’s because short-term capital gains taxes are steeper than the long-term variety.
An easy way to make sure that an investor is rarely or never on the hook for those short-term rates is to subscribe to a buy-and-hold investment strategy.
This can be applied as an overall investing strategy in addition to one tailor-made for avoiding additional tax liabilities on mutual fund holdings.
4. Talk to a Financial Professional
Of course, not every investor has the same resources, including time, available to them. That’s why some investors may choose to consult a financial advisor
who specializes in these types of services.
They usually charge a fee, but some may offer free consultations. For some investors, the cost savings associated with solid financial advice can outweigh the initial costs of securing that advice.
Getting taxed on capital gain on a mutual fund is unavoidable, but with a little help from a tax professional, you can minimize the amount you get taxed.
Some of the above strategies can work in concert: Investors who are investing for long-term financial goals, like retirement, can use tax-deferred accounts as their primary investing vehicles.
And by using those accounts to invest in mutual funds and other assets, they can help offset their short-term tax liabilities.
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