Mutual funds can end up being tax inefficient investments for many reasons. Investors may be making taxable transactions when they do not know it.
Writing check against mutual fund investments.
One way this could happen is if your mutual fund allows you to write checks against your investment in the fund. Every time you write a check against your mutual fund account, you have made a partial sale of your interest in the fund. Thus, except for funds for which share value remains constant, you may have taxable gain (or a deductible loss) whenever you write a check. Moreover, each such sale is a separate transaction that you have to report on your income tax return.
Changing mutual fund allocation
Here’s another way you can unexpectedly make a taxable sale. If your mutual fund sponsor allows you to make changes in the way your money is invested-for instance, lets you switch part of your investment from one fund to another fund-making that switch is treated as a taxable sale of your shares in the first fund.
Mutual Fund Recordkeeping
Recordkeeping is important. Be very careful about saving all the statements that the fund sends you-not only official tax statements, such as Forms 1099-DIV (or the fund’s version of the 1099-DIV), but the confirmations that the fund sends you when you buy or sell shares, or when your dividends are reinvested in new shares in the fund. Unless you keep these records, it may be difficult for you to prove how much you paid for the shares, and thus, you won’t be able to establish the amount of gain that is subject to tax (or the amount of loss you can deduct) when you sell them.
Tracking Basis in Mutual Funds
You will also need to keep these records to prove how long you’ve held your shares, e.g., more than 12 months if you want to take advantage of favorable long-term capital gain tax rates. (If you get a year-end statement that lists all your transactions for the year, then you can just keep that and discard quarterly or other interim statements or confirmations. But save anything that specifically says it contains tax information.)
Keeping Track of Mutual Fund Cost Basis
For mutual fund shares acquired after 2011, recordkeeping is simplified by new rules that require funds to report the customer’s basis in shares sold and whether any gain or loss is short-term or long-term. Time your purchases and sales. If you’re planning to invest in a mutual fund, there are some important tax consequences that you should take into account in timing the investment. For instance, an investment shortly before payment of a dividend is something you should generally try to avoid.
Receiving and Reinvesting Mutual Fund Dividend
Your receipt of the dividend (even if reinvested in additional shares) will be treated as income and increase your tax liability. If you’re planning a sale of any of your mutual fund shares near year-end, you should weigh the tax and the non-tax consequences of a sale in the current year versus a sale in the next year. Identify the shares you sell. Where you sell fewer than all of the shares that you hold in the same mutual fund, there are complicated rules for identifying which shares you have sold. The proper application of these rules can reduce the amount of your taxable gain or qualify the gain for favorable long-term capital gain treatment.
“Tax-managed” mutual funds
There is a relatively new breed of fund, so-called “tax-managed” mutual funds, whose managers are required to employ a series of strategies designed to keep the investors’ tax consequences to a minimum. Most of the large, well-known mutual fund organizations have established tax-managed funds. The techniques employed by these funds are also used by many sophisticated investors in managing their own personal portfolios.
What are Tax Managed Mutual Funds?
• Taking a long-term view of investing, or, in other words, trying to avoid short-term capital gains that would be taxed to the investor at his regular tax rate.
• Reducing investment income by investing in lower-yielding equity securities that are expected to show capital appreciation.
• When selling a portion of a holding, minimizing the gain by selling those shares with the highest cost basis first.
• Selling securities that have gone down in value to generate capital losses that can be offset against realized capital gains.
Index Funds (ETFs) versus Mutual Funds Tax
In addition to tax-managed funds, you might want to also consider index funds. These are funds which invest in the stocks making up a particular market index, for example, the Standard & Poor’s index of 500 large companies. Because these funds stay invested only in the stocks making up the particular index, there are relatively few sales of stock from the portfolio and hence only a small amount of capital gain. (Sales are generally made only when there are changes in the component stocks in the index or to generate cash to satisfy redemption requests from fund shareholders.)