Taxes can be complicated, and for mutual fund investors, they can be extremely complicated. Taxes may be imposed on dividends and income if you own mutual fund shares, in addition to capital gains taxes when you sell your fund shares. You don’t even have any influence on when you can make a profit on the fund’s investments, because that decision is made by the fund manager on behalf of all shareholders.
But once you break things down into the different types of taxes, it’s actually quite simple. Here are the top mutual fund taxes to keep in mind and some strategies to minimize these taxes.
Taxes on investment funds
Mutual funds can be a good choice for investors because they allow you to hold a diversified portfolio of securities for a relatively small investment. But investing in mutual funds means that you have no control over the individual investments in the fund, which is chosen by the fund manager. The fund’s price, or net asset value (NAV), will rise and fall based on the performance of the underlying investments in the fund.
Even if you still own the fund, mutual fund shares can be taxed in two ways:
- Dividends and interest: If the fund holds securities that pay dividends or interest, the fund will pay your share of those payments to you and you will owe taxes on that income. Some mutual funds, such as municipal bond funds, focus on investments that are exempt from federal income taxes. If you receive dividends or interest from a fund you own, you will likely receive an IRS tax form showing your income from the fund for the year. The form can come from the fund company itself, or from your online broker.
- Added values: The fund manager may sell securities in the fund at a profit, triggering a capital gains tax. The tax impact will depend on how long the fund holds the shares sold. The capital gains are distributed, usually once a year, to the fund’s shareholders, who are liable to pay tax on the gains.
For more information about taxation of investment income, please visit IRS Publication 550.
Mutual fund taxes when you sell stocks
If the securities in your mutual fund perform well, the net asset value of the fund will increase, giving you a profit on your original purchase. You’ll have to pay taxes on these profits, but figuring out exactly how much you owe can be complicated.
If you bought your shares in one go, the calculation is relatively simple. You subtract the price you paid per share from the price you sold for and the difference equals your profit per share. But most people buy mutual funds consistently over time, meaning you’ve paid different prices for your shares. 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.
It also matters how long you have owned your shares. If you hold the shares for more than a year, you may receive a reduction in the capital gains tax rate because the gains are considered long-term. For gains on shares held for less than one year, you pay tax at the ordinary income rate.
How to Minimize Taxes on Mutual Funds
Mutual fund taxes are a sign that you’ve received some form of investment income or realized gains, so they’re not all bad. But avoiding taxes can help you earn higher returns in the long run. Here are some of the best ways to minimize taxes on mutual fund investments:
- Hold shares in tax-advantaged accounts: One of the easiest ways to avoid taxes on mutual fund investments is to hold the shares in tax-advantaged accounts, such as a 401(k) or a traditional or Roth IRA. Your investments are allowed to grow tax-free, which means you don’t pay tax on the distributions you receive or the profits you realize. You also don’t pay taxes on withdrawals, in the case of a Roth IRA.
- Hold money for the long term: By holding funds for more than a year, you can pay taxes at the long-term capital gain rate, which is a big benefit for most investors.
- Avoid certain types of funds: If you want to avoid taxes, you probably want to avoid funds that focus on dividends or funds with high portfolio turnover, both of which can produce a lot of realized gains. Index funds may be the best choice because they typically pay modest dividends and have low turnover.
- Harvesting tax losses: Using a tax-loss harvesting strategy involves selling certain investments at a loss to offset your gains, reducing your tax liability.
You can also limit your tax risk by holding exchange-traded funds (ETFs) instead of mutual funds. ETFs often hold similar investments to their mutual fund counterparts, but are not required to distribute realized capital gains, making them more tax efficient.
In short
Mutual fund taxes can be complicated because you can be taxed on dividends and the fund’s gains even before you sell your shares. Of course, you will also be taxed on any gain in the value of the fund when you decide to sell. The easiest way to avoid this is to own mutual funds in tax-advantaged retirement accounts like IRAs and 401(k)s. You can also make sure you hold the investments for the long term so that when you owe taxes, you pay them at the lower long-term capital gain rate.
