Mutual fund strategies to reduce your taxes
by Marvin Appel, PhD, and Brian Hufford, CPA, CFP
This is the time of year when we are occupied with paying taxes on last year's income. However, for mutual fund investors, it is also an excellent time to start planning your investments to reduce the coming year's tax bite.
Unlike individual shares of stock, you may have to pay significant taxes on your mutual funds each year even if you hold the shares continuously for years. New SEC regulations will require funds to report the historical total return on both a before-tax and an after-tax basis so that investors can judge how much impact taxes have had on past returns. (Of course, future tax consequences and investment performance may differ.)
Needless to say, having to pay taxes along the way negates one of the important advantages of long-term holding. Fortunately, you can implement two basic strategies to minimize this type of tax bite until you actually sell your own shares: 1). Timing your mutual fund purchases appropriately, and 2). Selecting tax-advantaged funds.
You may owe taxes on mutual funds — even if you didn't sell
By law, funds must distribute over 95 percent of all realized gains to shareholders at least once each year. As a practical matter, most equity funds choose a "record" date to determine the list of shareholders who get the gains. Each shareholder of record on that date receives a proportion of long- and short-term capital gains, regardless of how long the shares have actually been held.
Most mutual funds will distribute gains as additional shares (unless you specify otherwise). The record keeping can get very complicated; after a distribution of shares, you would have some shares at the original purchase price and additional shares with a different cost basis. (When you take a distribution in shares, the cost basis for the new shares is the price of the shares on the date they are distributed.)
Why mutual funds create tax liabilities for their shareholders
There are two main reasons for capital gains distributions:
- The fund manager may want to switch from a current holding into one that may perform better. This is the same choice every individual faces when deciding to sell one stock and incur a tax liability to buy another that will hopefully be a better investment.
- The other reason is that if enough shareholders choose to pull their money from a fund, the fund may have to sell shares of stock to meet the redemption requests.
The tax consequences of such liquidation, however, fall on both the remaining shareholders as well as on those whose redemptions actually triggered the tax liability. Any time a fund sells a holding at a profit you are liable for the tax consequences, even if you are a brand-new shareholder.
This may be true even if the fund realized the gain before you became a shareholder. In some cases, shareholders have lost money in a mutual fund and also had to pay taxes on capital gains realized when a fund closed one of its profitable positions. Such a double whammy is a particular risk at the start of a bear market.
Tax-efficient mutual funds
A number of funds run their portfolios in a manner designed to reduce the tax impact of their investment decisions. The best tax treatment you could possibly achieve with a tax-managed fund would be to pay taxes on dividends (no way around that), but, beyond that, to pay capital gains only when you buy or sell your own holdings.
Vanguard (800-662-2739) has several tax-managed funds covering a range of investment styles including large-cap, small-cap and balanced (stocks and bonds), and low-expense ratios.
Some of their funds impose redemption charges if you redeem shares within the first few years. Verify the length of your commitment before you invest.
Index funds as a group are another tax-efficient alternative. Most stock indexes change little in their composition from year to year, and, with an index fund, you get the added benefit of knowing the composition of the portfolio and how it has performed historically over the long term. No matter what mutual fund you choose, however, you may be liable for a large taxable distribution in the event of extremely large shareholder redemptions.
Exchange-traded funds (ETFs) are available to track a large variety of indexes and are virtually immune to taxable distributions beyond dividends or changes in the composition of the underlying index. However, you will incur brokerage and other transaction costs with ETFs, making them unsuitable for investors who add small amounts of capital frequently. If you plan to hold on to the fund for five years or more, and if you use a discount broker, ETFs could be the lowest cost, most tax-efficient investment.
Why worry about tax-efficient funds now?
If 2002 turns out to be profitable for the market (as many expect but none can guarantee), the longer your investments spend in tax-efficient investments, the more valuable tax-wise portfolio management is likely to be for you. Of course, there may be little or no advantage to placing assets in tax-managed funds if you expect to withdraw them within a year or two.
Tax-deferred accounts. With IRAs or other qualified plan accounts, you do not have to concern yourself with tax-managed funds. No tax is due until you withdraw assets from the retirement plan account. At that point, all such withdrawals are taxed at the same (ordinary income) rate.
Timing fund purchases to minimize tax liability. Most mutual funds pay out their capital gains distributions in November or December. It is usually not difficult to discover the record date; however, many funds are reluctant to disclose the size of the distribution they expect to make because they do not want to trigger large redemptions from the fund from investors who would sell only to avoid the tax liability.
However, November and December have historically been strong times for the stock market. If your investment goals would normally call for you to add to your mutual fund holdings around the end of the year, it might not be to your ultimate benefit to postpone.
If you are looking to move from one fund to another, try to postpone the move until you are sure the fund you are buying has already made its capital gains distribution.
If you are adding new money to the market before a capital gains distribution occurs, you may have to switch to a different mutual fund to avoid paying capital gains taxes on profits you never enjoyed.
What to do if you get hit with a large capital gains distribution
You may be able to sell your shares and offset the gains, or use the distributed gains to offset any investment losses you may have elsewhere.
Capital gains distributions lower the price of your original shares. (You get enough new shares to make up for the lower share price, so the distribution does not affect the total value of your investment.)
As an example: Suppose you buy 1,000 shares at $9 ($9,000 cost basis). The shares rise to $10 (gain of $1,000), current value of investment = $10,000). Then, a $2 per share distribution occurs ($2 x 1000 shares = tax due on $2,000).
The new share price is $8 ($10 share price less the $2 distribution). In order for your investment to remain worth $10,000, you receive 250 new shares. So, you owe capital gains taxes on $2,000 even though your investment gain is only $1,000.
If you sell your shares at $8, you realize a loss of $1 per share, since the purchase price was $9. This generates a loss of $1,000 that can offset your taxable gains distribution of $2,000.
If you sell your shares, your net tax liability ends up being due only on your actual economic gain. This is better than paying tax on a profit you never earned, but still requires you to realize a gain solely for tax management rather than one based on investment considerations.
Note that if your unrealized gains in a fund equal or exceed the amount of the distribution, it does not make sense to sell shares. Doing so would increase your tax liability compared to holding on to your original investment.
Also note that if you sell your shares at a loss from the original purchase price to offset a capital gains distribution — or for any other reason — you must stay out of the mutual fund for at least 31 days to avoid running afoul of "wash sale" tax rules.
Mutual fund investors owe taxes on whatever gains the underlying fund portfolio has realized in its fiscal year, regardless of whether the individual shareholder enjoyed the benefits of those realized gains.
Some simple strategies can minimize the impact of the tax bite on the long-term growth of your assets:
- Consider tax-managed, index, or exchange-traded funds for your long-term holdings in nonqualified accounts.
- If you plan to buy a fund near the end of the year, try to make the purchase after the dividend is paid.
- If you do get hit with a capital gains distribution larger than your own unrealized profit, see if you have losses elsewhere to offset it. Otherwise, move assets out of the fund (possibly to a different fund with similar investment objectives to maintain your stock market exposure).
- If you do sell a fund at a lower share price than your original cost, stay out it for at least 31 days. (This advice applies whether you sold to offset a tax liability from a distribution or just to close out a losing position.)
