Generally, balanced funds stick to a relatively fixed proportion of stocks and bonds but may also ha...
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Tax Strategies for Fund Investors
12/25/2019 5:00 am EST
Many mutual fund investors focus on the fees they pay but don’t pay enough attention to the taxes on their investment returns, asserts Bob Carlson, editor of Retirement Watch.
Taxes are a greater drag on net investment returns than expenses and fees, according to a study by Rob Arnott of Research Affiliates. Most investors leave a lot of money on the table by overlooking important tax tricks of funds and focusing on taxes only near the end of the year.
Don’t let that happen to you. Review these simple rules about mutual fund taxes and keep them in mind all year. As markets change, consider tax-wise actions to take with your funds.
You want to own the right assets in the right accounts when possible. Owning the right investments for you comes first. To the extent you can, own the assets in the most tax efficient accounts for them. If most of your money is in an IRA or 401(k), you might not be able to have all the right assets in the right accounts.
That’s one reason I recommend tax diversification. It’s a good idea to have taxable accounts, tax-deferred accounts and tax-free accounts. A good general rule for putting the right assets in the right accounts is to hold assets that already receive tax advantages in taxable accounts.
Stocks, mutual funds and other assets you’ll hold for more than a year should be in taxable accounts to take advantage of long-term capital gains. Stocks that pay qualified dividends usually should be in taxable accounts. Tax-deferred accounts should hold assets that earn short-term capital gains and taxable interest.
Tax-free accounts, such as Roth IRAs, also should own these types of assets. Real estate investment trusts (REITs) are a hybrid but generally should be held in tax-deferred or tax-free accounts.
You might want to hold treasury bonds or treasury-only mutual funds in taxable accounts, because their interest is exempt from state income taxes.
Those are general rules. Let’s move beyond those basics to a higher level of mutual fund tax planning. You know that a mutual fund avoids income taxes by distributing to shareholders most of its net interest, dividends and capital gains. Only the shareholders are taxed on the income.
Shareholders on the date of the distribution pay the taxes. If you buy shares in a taxable account the day before a distribution, the distribution will be included in your income for the year, though it really is a return of your investment. The net asset value of the shares is reduced by the amount of the distribution.
When you’re investing or considering an investment in a mutual fund, know its regular distribution dates. You want to make new investments just after, not before, a distribution.
When you made an investment shortly before a relatively large distribution, there’s a strategy you might want to use to reduce the tax burden on the distribution. Suppose Max Profits invests in a fund with a $15 net asset value per share. The fund distributes $5 per share the next day.
Max now has $5 of income and shares with a net asset value of $10 and a basis of $15. Max can have the shares redeemed for $10, realizing a $5 short-term capital loss that offsets the distribution.
The strategy might not be worth doing if the fund has a redemption fee on short-term holdings or if Max invests through a broker who charges transaction fees on the trades. In addition, to be able to deduct the loss, Max has to wait more than 30 days to re-invest in the fund.
It is best to know a fund’s distribution schedule and avoid buying new shares shortly before a redemption. You don’t want to own mutual funds in a taxable account that distribute a lot of gains and income each year. The taxable account should be for investments that let gains compound for years with minimal annual distributions.
If a fund has a total return of $8 per share during the year, you don’t want it to distribute $4 of that return so that you have to pay taxes on them. You want the gains to stay in the fund and compound over time. You want to be able to control when most of the taxes are incurred, and you want them to be long-term capital gains.
To decide which funds to own in taxable accounts, study a fund’s turnover ratio and distribution history. The turnover ratio is a measure of the frequency of a fund’s trading.
A fund that trades frequently has a high turnover ratio and usually is generating a lot of gains, especially short-term gains, that will be distributed to shareholders by the end of the year. You can find a fund’s turnover ratio in its prospectus and in many of the online data sources of mutual funds. The turnover ratio is a rough measure of a fund’s likely annual distributions.
A more precise measure is a fund’s distribution history. The fund’s prospectus and many online sources list the amount of the distributions made in recent years. You can see if the fund regularly has high distributions, periodically makes high distributions, or keeps its annual distributions low.
The prospectus and many online sources also provide a table that compares the total return of the fund to its after-tax return for a hypothetical shareholder.
Two funds can have identical total returns over time. Yet, their shareholders can have dramatically different after-tax returns because of differences in annual distributions. It also is a good move to check the types of distributions a fund has made.
When a fund owns an investment for more than one year before selling, any gain produced is a long-term capital gain. When the gain is distributed to shareholders, they report it on their returns as long-term capital gains. The shareholders retain the tax advantages of the long-term gains.
But when a fund sells a winning investment after owning it for less than one year, it distributes short-term gains that shareholders must report as ordinary income to be taxed at their regular rate. When a mutual fund has a high turnover ratio or a history of large distributions, try to own that fund in a tax-deferred or tax-free account instead of a taxable account.
A little-known trick is to check a fund’s prospectus or the online data sources for the amount of its loss carryforwards and unrealized gains before deciding which fund to buy. When a mutual fund has net losses from its transactions for the year, it doesn’t distribute those losses to shareholders.
Only net gains and income are distributed. The losses are kept on the fund’s books and can be used to offset future gains. If a fund had a poor year or stretch of bad years, it might have loss carryforwards on its books. Those carryforwards will shelter future gains from taxes.
You don’t want to buy a dog of a fund simply because it has loss carryforwards. But when you’re considering funds with similar long-term records, one with high loss carryforwards might generate higher after-tax returns than one with few or no carryforwards. You might want to search for loss carryforwards when an investment sector has been down for a couple of years and you’re thinking it’s ready to turn around.
Another time to examine carryforwards is when a fund had a rough couple of years because a small number of its investments did poorly, but you think the fund is ready to turn around. Investors buy index funds partly because of their tax efficiency. Index funds usually make fewer trades than most active funds, so they have lower distributions.
That’s the general rule, but it doesn’t apply to all index funds. Some fund companies manage their index funds with more tax efficiency than others. The money managers at those fund companies work hard to offset gains with losses. Others are much more passive and have higher taxable distributions.
The taxable distributions also vary because funds have different ways of tracking an index. Some funds buy the individual stocks in the index. But others use futures, options and other tools for at least part of their portfolios. These positions trigger gains as they mature, which happens frequently, and the gains usually are short-term.
These situations are especially likely for funds that track an index other than a large-company stock index. The less liquid the index tracked by a fund, the more likely it is that the fund will deviate from the index, will use methods other than direct ownership of the stocks and will have higher taxable distributions.
Any mutual fund can lose control of its tax situation when it experiences a large amount of redemptions. A redemption run can occur when investors lose interest in the sector the fund invests in or decides better funds are available. As investors redeem their shares, the fund has to sell investments to meet the redemptions. If the sales result in gains, the shareholders who remain in the fund pay taxes on the distributions of the gains.
Some investors refer to this as the death spiral or tax spiral. The longer you stay in a fund that is losing shareholders, the larger your annual tax bill is likely to become. Index investors should compare openend mutual funds to exchange-traded funds (ETFs).
ETFs have some tax tricks and strategies available that open-end funds cannot offer investors. Any fee you pay to buy the ETF through a broker might be negligible compared to the tax savings over time. Mutual funds encourage investors to automatically reinvest distributions.
There are some good reasons to do that. But over the long run, when the fund is held in a taxable account, reinvestment of distributions results in more headaches and tax issues.
Each time a distribution is reinvested, your basis in the new shares is their value on that date. Most people go for years holding a fund and reinvesting distributions.
They have a bunch of shares bought at different times and different prices. When they’re ready to make partial sales of their holdings to fund retirement, they have a complicated tax picture. They have to determine the tax basis and holding period of each share sold.
It is better to avoid automatic reinvestment of distributions. Instead, let distributions accumulate in a money market fund. Then, use the account to rebalance your portfolio by purchasing new shares in funds that have lagged the others.
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