How To Be Tax-Efficient When Investing In Mutual Funds

According to a study by Joel Dickson and John Shoven1, as much as a quarter of mutual fund investors’ annual returns are consumed by the taxes payable on dividend and capital gains distributions. Also, the type of mutual funds you purchase, the time of purchase, and the length of time you hold the fund has an impact on taxes and ultimately the return on your investment.  By following a few simple suggestions when you buy or sell mutual funds, you will decrease your taxes so more of your money will end up working for you.

Invest in Index Funds Rather than Actively Managed Funds

With mutual funds you pay taxes each year on your share of the capital gains realized within the fund’s portfolio. This is known as a “capital gain distribution”.  By purchasing index funds rather than active mutual funds, you can avoid large taxable capital gain distributions at the end of the year.

Be Careful if you Plan to Purchase Mutual Funds at the End of the Year

Mutual funds generally distribute their capital gain at the end of the year.  So, if you decide to purchase active mutual funds it’s best not to do so at the end of the year. If you do, you’ll be forced to pay the taxes on the distributions even though you didn’t earn any of the capital gains. If in doubt, look up the distribution date of the fund and buy it after that date.

Hold Your Investments for 1+ Years and You’ll Pay Less Tax

Capital gains are either short-term or long-term depending on how long you’ve held the mutual fund. If you hold the fund for a year or less, it’s short-term. If you hold it for more than one year, it’s long-term. The taxes on short-term gains are taxed at ordinary income rates that can be as high as 35%. Long-term gains are taxed at a maximum of 15%. So it generally makes sense to hold funds for more than a year to avoid short-term capital gain tax rates.

Qualified Dividends Instead of Ordinary Dividends

Qualified dividends are dividends issued primarily by U.S. Corporations that meet specific criteria that qualify them for long-term capital gain tax treatment. By using mutual funds that purchase companies who issue qualified dividends, for tax years 2011 and 2012, you can reduce your taxes from a maximum of 35% to a maximum of 15%.

Tax Loss Harvesting to Offset Gains

Tax loss harvesting is the process of selling mutual funds at a loss to offset capital gains generated by selling other mutual funds for a profit. Let’s say you want to sell a mutual fund, but doing so would produce a short-term capital gain. You might search through your portfolio to find another mutual fund which has an unrealized loss for the year. You can sell that mutual fund at a loss to offset the short-term capital gain of the first mutual fund.  Each year, capital losses must first be deducted from capital gains (if any).  If net capital losses exceed net capital gains, you may deduct up to $3,000 in the current year from other income. Net capital losses over $3,000 have to be carried over to future years. Be aware of the wash sale rule below.

Wash Sales will Defer the Tax Loss

A wash sale is a sale of a mutual fund at a loss and repurchasing the same or substantially identical fund within 30 days before or after the sale.  If you have a wash sale you cannot take the tax loss for that transaction in the current year. But you don’t lose the ability to take the loss at a later date because when you sell the substantially identical fund, the basis of the fund is increased by the amount of the disallowed loss.

Mutual Fund Cost Basis

You can elect to sell high cost funds first using “specific identification” rather than “average cost” basis or “first-in first-out (FIFO)”. Doing so will minimize recognized gains. Be aware that the specific identification needs to take place at the time of the sale, not at the time of tax preparation.

Tax-Free Municipal Bonds

Fixed income mutual funds (bond funds) generally pay interest which is taxed at ordinary tax rates up to 35%. But mutual funds that purchase municipal bonds are exempt from federal taxes.  And, if you invest in a fund that purchases in-state municipal bonds, you will also avoid state taxes. Watch out for municipal bond funds that invest in certain “private activity bonds”, which may be subject to Alternative Minimum Tax (AMT).  Private activity bonds were exempt from the AMT adjustment for tax years 2009 and 2010.

Other Considerations

Many of these strategies can be combined to save a significant amount of taxes on your investments. You should discuss with your financial advisor and CPA to see how these strategies may affect you.

You should never let the opportunity to save taxes override your general investment strategy with regard to risk and diversification.

Keep in mind that this advice applies primarily to taxable accounts, not IRAs or employer plans. In general, investments generating ordinary income should be held in retirement accounts to avoid current taxation. Investments held primarily for long-term appreciation should be held in taxable accounts.

1Joel Dickson and John Shoven, “Taxes and Mutual Funds: An Investor Perspective” in James M. Poterba’s (ed.) Tax Policy and the Economy, 1994

About the author

Russell D. Francis, CPA, CFP®
Russell D. Francis, CPA, CFP®

Russell D. Francis, CPA/PFS, CFP® started Portland Fixed Income Specialists, LLC in 2012. Portland Fixed Income Specialists is an Oregon fee-only Registered Investment Advisor. We do not accept commissions for financial products or referral fees. Every decision we make is based on the best interests of our clients.

We simplify the financial planning process for you by carefully considering how it applies to your unique situation. We then provide you with the information, advice and alternatives necessary to align your financial decisions with your values, needs, and goals in life. The benefits of this approach are many – you enjoy a greater understanding of the choices you make and are confident when implementing those choices.

And, because we’re a Certified Public Accounting (CPA) firm as well as a Registered Investment Advisor, you benefit from our knowledge of the complex relationship between investments and taxes.

2 Comments

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  • One thing I don’t see mentioned here is asset location, that is, putting your least tax efficient asset classes in tax advantaged accounts such as a 401k or IRA. When your tax advantaged space is filled, put the most tax efficient asset classes in your taxable space.

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