Investment Strategies

Mutual funds are convenient, but they can produce tax bills that surprise new investors. Because a fund pools many investors' money and trades inside the fund, you can owe tax even in a year when you never sold a share. Understanding where the tax comes from lets you make smarter choices.

How Mutual Fund Income Is Taxed

Held in a taxable account, a fund can generate three kinds of taxable activity:

• Dividends and interest passed through from the fund's holdings. Some qualify for lower long-term rates; others are taxed as ordinary income.
• Capital gain distributions that occur when the fund manager sells holdings at a profit. These are taxed according to how long the fund held the assets, not how long you held your shares.
• Gains when you sell your own shares, based on the difference between your cost basis and the sale price.

Even if you reinvest every distribution automatically, you still owe tax on them for the year.

Ways to Reduce the Bite

• Use tax-advantaged accounts. Funds that throw off lots of income or turnover fit best in IRAs and 401(k)s, where annual distributions are not taxed currently.
• Favor tax-efficient funds in taxable accounts. Index funds and exchange-traded funds typically trade less and tend to distribute fewer gains. Municipal bond funds pay interest that is generally exempt from federal income tax.
• Watch the calendar. Funds often make capital gain distributions late in the year. Buying just before the distribution means you receive a taxable payout that is really a return of your own money.
• Hold for the long term. Shares held longer than one year generally qualify for long-term rates that are lower than ordinary rates.
• Harvest losses. Selling losing positions can offset gains elsewhere, subject to the wash-sale rule, which disallows the loss if you buy substantially identical securities within 30 days before or after.

Keep Good Basis Records

Your cost basis includes what you paid plus reinvested distributions. Forgetting reinvested amounts means paying tax twice on the same money. Brokers report basis for most shares purchased in recent years, but older purchases and transfers between firms may need your own records. When selling part of a position, you may choose a method such as average cost or specific shares, and that choice can change your tax result.

Do Not Let Taxes Run the Whole Plan

A fund's strategy, fees and fit with your goals matter more than any tax trick. Use tax planning to improve the after-tax result of a sound investment plan, not to replace it. The SEC's investor education site at investor.gov offers general guidance on fund costs and structure.

If you would like help reviewing your fund holdings from a tax standpoint, learn about our tax planning services or contact us.