Cut Your Mutual Fund Taxes

Ah, the joys of mutual fund investing. Easy as pie: Find a fund you like with nice returns and voila, you are in the money. But if you socked away money in a mutual fund outside your retirement plan, you may be in for a big tax surprise.

Why You Get Taxed

Your tax bill is the last thing on an actively managed fund's list of concerns, says Grace Weinstein, author of The Complete Idiot's Guide to Tax-Free Investing: "What investors have to realize is that managers earn their compensation on the basis of raw returns, and they have no interest in keeping taxes down."

Managers of most mutual funds will buy and sell their holdings (the stocks in the fund) as often as possible to maximize profits. But every time they sell a stock at a profit, the fund is hit with capital-gains taxes -- and funds pass along those taxes to all shareholders in annual distributions. That means taxable short-term and long-term capital gains are billed to you, at rates of up to 35 percent on short-term gains and up to 15 percent for long-term gains.

Also watch out for hidden tax liabilities. "You get the distributions that the fund gained whether or not you sell your shares," Weinstein said. "There have been warnings that you could have a down market and lose a substantial amount of your holdings and still be hit with capital gains tax because of transactions the fund made."

Tax-Managed Funds

To beat Uncle Sam at his game, consider tax-managed funds, which are designed to lessen your tax bite. Tax-managed funds aim for low portfolio turnover and strive to limit yearly capital-gains distributions. The number of such funds is growing, and tax-managed funds are available from companies like Schwab and Vanguard.

Like other mutual funds, tax-managed funds invest in typical categories such as growth stocks, municipal bonds, and large-cap stocks. But managers of these funds use certain strategies to keep taxes lower than actively managed funds. They buy stocks with no or low yields to minimize dividend income. They also follow the tried-and-true strategy of buy-and-hold to keep from accruing short-term gains.

When choosing a tax-managed fund, remember to compare its returns with similar mutual funds on an after-tax basis. You might find that a regular fund's after-tax return is still higher than a tax-managed fund's numbers.

Other Tax Strategies

Besides tax-managed funds, how else can you keep mutual fund taxes down? When choosing a fund, check out the turnover rate (listed in the prospectus). A high turnover rate is an important clue that taxes might be high. Also, a change in management could mean a big shuffle in a fund's portfolio, resulting in a taxable gain for you.

Also try these strategies to help you keep more of your money.

  • Use tax shelters. Of course, your easiest plan is to take advantage of tax deferral through your 401(k), IRA and Keogh plans. "Although they are eventually taxed, years of tax-free growth makes it worthwhile," Weinstein said. "A 401(k) with a company match is like a tax-free guaranteed return on your money. If you're getting 50 cents on every dollar, that's like a 50 percent return."
  • Buy index funds. Managers of these funds use a passive strategy that yields a low portfolio turnover rate.
  • Keep trading down. You may not be able to control a fund manager's trading, but you can control your own trading. The less you trade in your taxable accounts, the less you'll owe Uncle Sam.
  • Try municipal bonds. Look to municipal bonds, which are exempt from federal and in some cases state and local income taxes.

    Investment experts warn that you shouldn't let fear of taxes be your only guide when investing. But when it comes to tax planning, says Weinstein, there's no time like the present. "You should be watching it year round, but definitely before year-end," she said. "Tax planning in spring is too late."

Connect with Us
Follow Our Pins

Yummy recipes, DIY projects, home decor, fashion and more curated by iVillage staffers.

Follow Our Tweets

The very dirty truth about fashion internships... DUN DUN @srslytheshow

On Instagram

Behind-the-scenes pics from iVillage.

Best of the Web