How to Avoid Overpaying Tax on Mutual Funds

Mutual funds can be taxefficient investments – that is, as long as you are aware of the strategies necessary to avoid overpaying the IRS

Investing in mutual funds is a way for investors to pool security ownership with other investors. But when you’re considering taking advantage of the benefits of mutual funds, make sure you don’t overpay in taxes. Here are certain funds to consider and behavior strategies to follow that will ensure you maintain tax-efficient investments:

Tax-efficient funds

First, let’s look at index funds. This type of mutual fund passively matches or tracks a market fund, such as the S&P 500. But unlike actively managed funds, therules and selections don’t change based on what the market does. Not investing directly in the market has many benefits, such as low operating costs and low portfolio turnover. Because of this low turnover, these investments are tax efficient and less expensive to manage than actively managed funds, which investors frequently buy and sell. Plus, index funds are diverse, so your funds are spread out and betterprotected from big losses.

An exchange-traded fund (ETF) is a type of index fund which trades on a major stock market, like the New York Stock Exchange. ETFs are generally investments with lower risk and lower costs, and are bought and sold throughout the day like stocks, meaning investors can place different types of orders. (Mutual funds, on the other hand, settle when the market closes.) Costs are lower because there’s no sales load, though you will pay commissions. But the better tax efficiency comes from investors being able to control when the capital gains tax is paid.

Another type of tax-efficient mutual fund is a tax-managed fund. These funds help reduce the amount of capital gains tax you pay by harvesting losses to offset gains. You see capital gains either by selling shares or by receiving embedded gains, which happen when the fund sees a gain from the sale of a share and that gain is passed to you as share holder. Tax-managed funds aim to reduce that second type of gain that you’ll have to pay tax on, whether by harvesting losses (mentioned above), avoiding turnover, or selling certain shares to minimize taxable gains.

Basically, you control when you realize your capital gains. And in some instances, thesefunds may have early-redemption fees that deter withdrawals which could forcemanagers to sell and thus see capital gains.

The last type of investment worth mentioning is a separately managed account (SMA). These accounts differ from mutual funds in that you have an account manager who directs securities that you own on your behalf. SMAs can help you avoid turnover and you may see opportunities to take advantage of tax swaps. Just keep in mind that the fees on SMAs could be a bit higher than mutual funds.

Tax-efficient behavior

You want to ensure that your investment behavior actually takes advantage of the tax benefits you can see from the above types of funds. Many investors don’t fully understand the tax implications of mutual funds, The New York Times notes.

First, try to avoid large lump-sum distributions. For tax-deferred accounts, like retirement accounts, you’ll see a big tax bill if you opt for one large lump-sum withdrawal. Instead, try rolling the money over or spreading out the distributions over several years.

Also try to limit the amount of turnover on your mutual funds. When you trade frequently, the capital gains you see may be subjected to high income-tax rates, instead of better long-term capital gains tax rates.

When applicable, try tax loss harvesting, or tax swaps. This strategy allows you to use capital losses (when you sell a fund for less than you bought it) to offset any capital gains. This can help you reduce or manage your tax bill from capital gains.

Keeping dividend payout timing in mind is another important strategy to manage taxes. The capital gains you accrue throughout the year are paid out as the end of the year is nearing. Avoid buying shares right before that happens, since you’ll have to pay taxes on gains before you may see any profit from the shares. In contrast, selling shares before the dividend date can help you avoid overpaying on tax by avoiding higher ordinary income tax rates versus capital gains tax rates.

When you’re ready to look at your investment portfolio with an experienced financial professional, Provident CPA andBusiness Advisors is here to help. We ensure you pay the least tax legally possible and help you create a diverse and balanced investment portfolio. Get in touch with our team today to learn about how we help our clients create investment strategies that work.