What Do I Need To Know About Mutual Fund Taxes?

Posted by Jim Kantowski, CFP®, CPA on July 14, 2022

What Do I Need To Know About Mutual Fund Taxes?

Investing your money in mutual funds is a great way to diversify your portfolio by gaining access to different asset classes and countries in a simple and low cost manner. However, as is the case with any investment, you should understand the tax consequences of mutual funds before you purchase them—because the implications can be significant. High mutual fund taxes have the potential to erode your investment returns or land you with an unexpected tax bill at the end of the year

Luckily, you can mitigate potential tax liabilities caused by mutual fund taxes. In this blog post, we’ll share a few key tips to help you pay less tax on mutual funds.

Are you looking for an investment plan that’s also based on tax expertise? At Bay Point Wealth, we take a comprehensive planning approach to your portfolio. Schedule a call with us today to learn more.

How are mutual funds taxed?

Tax on mutual funds is generated in two main ways. Let’s walk through both:

1. Income Distributions

When you invest your money in a mutual fund, it’s important to understand that subsequent transactions occur within the fund itself, independent of shareholders’ trades. To the extent that such transactions generate income for the fund, you are responsible for paying tax on distributions from the fund.

If the fund owns dividend-paying stocks, then dividends paid by these stocks are accrued and paid out monthly, quarterly, or annually to shareholders based on the number of shares owned by each individual shareholder. These distributions take the form of dividend distributions, which can be both qualified or non-qualified dividends, and have different tax treatments.

At the end of the year you will receive an income tax document, the Form 1099-MISC from the fund owned, detailing the amount and type of dividend paid. These distributions are considered taxable income and will potentially increase the amount tax you owe at the end of the year. Depending on the type of dividend, how the mutual fund is owned, and other income sources you may have, the income tax impact may be significant.

If you are holding a mutual fund that invests in fixed income you will also be required to pay tax on income generated by these types of investments. Fixed income investments such as bonds typically pay income on a more frequent basis and will be taxed at your ordinary income tax rate. However, certain types of bonds may pay interest that is excluded from either federal or state income taxes, or both.

2. Capital Gain Distributions

Capital gains generated within the mutual fund itself can also trigger distributions, and therefore, generate mutual fund taxes. If a mutual fund sells an investment in the fund at a gain, the fund must pass that gain onto you as a shareholder. Even if you didn’t sell and trigger the gain yourself, you could still be responsible for paying capital gains tax on your investment because you realized a gain from the fund’s trading activity.

Like dividend distributions, tax paid on capital gains generated by the mutual fund will depend on the amount paid, type (long-term or short-term capital gain), and the amount and type of taxable income you receive from other sources. If you haven’t been following communications from a fund you’re invested in, you may be unpleasantly surprised to learn of the tax bill.

There are a few key points to understand when it comes to mutual fund taxes caused by capital gains. First, a mutual fund may already contain built-up appreciation in stocks when you invest. If this is the case, you might be buying exposure to capital gains.

Second, internal transactions take place more frequently in some mutual funds than others. This is called turnover ratio. If you invest in a fund with a high turnover ratio, that means the fund manager is buying and selling often, which could expose you to more capital gain distributions. In contrast, investing in a fund with a low turnover ratio reduces your exposure to capital gains.

Pro Tip: Mutual funds disclose their turnover ratios. You can find this information through Morningstar, which enables you to review various funds and their ratios. For example, a fund manager who is buying and selling often to try to “beat the market” could have a high turnover ratio, whereas an index fund would have a lower ratio.

In addition to a fund manager buying and selling at a high rate, you could also run into capital gains if significant liquidations by other investors occur. Sometimes in a down market, investors will panic and sell shares of stock mutual funds to buy into a safer fund that holds bonds or cash. This would cause a mutual fund manager to have to sell highly appreciated investments to provide cash to investors looking to reduce exposure to stocks. These liquidations can generate capital gains, which would then be distributed to you, even if you stay put in your mutual fund.

What happens when you sell your mutual funds?

The quarterly or annual distributions you pay tax on during the time you hold a mutual fund actually help to reduce your tax bill when you sell, if you reinvest those distributions and purchase more shares.

Suppose, for example, you invest $100,000 in a mutual fund in a given year, and in the next year you have to pay taxes on $5,000 worth of quarterly distributions that are reinvested into the same mutual fund. Those taxable distributions get added to the tax basis of your investment. Thus, for the mutual fund in question, the basis would increase from $100,000 to $105,000.

If you were to later sell your shares in the fund for $115,000—at a point when your basis remained at $105,000—you’d still have to pay the capital gains tax since your investment appreciated, but the taxable gain would be $10,000 rather than $15,000, because the increased basis offsets your capital gains by $5,000. You are thus not taxed twice on the same gains.

6 Tips For Minimizing Mutual Fund Taxes

We’ve now answered the question, “How are mutual funds taxed?” and you know what to expect when you sell your investments in mutual funds. It’s time to get proactive and talk about how you can minimize tax on mutual funds.

1. Leverage tax-loss harvesting.

Tax-loss harvesting is a smart strategy to take advantage of when the market is down. For example, say you invest $100,000 in a mutual fund and your fund declines in value to $80,000. You can sell a portion of your shares and realize a loss, and quickly buy a similar (not identical) investment if you do not want your portfolio design to change.

Realizing the loss will allow you to offset current and future capital gains (to the extent realized), or you can use $3,000 per year to offset ordinary income. Be careful not to violate the wash-sale rule, which prohibits you from purchasing the same security for 31 days, or your loss will be nullified.

2. Buy funds with low turnover ratios.

This is a wise principle to follow at any time. At Bay Point Wealth, we always aim to choose mutual funds with low turnover ratios so our clients aren’t exposed to unnecessary capital gains tax. Index funds typically have the lowest turnover ratios, but you can also find tax-conscious fund managers that will do their best to minimize distributions. No one wants a big tax surprise from Uncle Sam!

3. Hold funds within retirement accounts.

If your money is invested in a mutual fund with a high turnover ratio or a high income distribution level, holding your investments within retirement accounts like a 401(k) or individual retirement account (IRA) can reduce your tax bill. This is because the money inside these accounts is tax-deferred. You can still receive distributions from a mutual fund, but as long as your money stays inside your retirement account, you won’t pay tax until you make a withdrawal.

4. Understand your capital gains exposure.

Knowing how all of your money is invested within a mutual fund is critical—i.e., is it invested in an actively managed fund, dividend stock portfolio, or an index fund? This will matter when tax time arrives.

5. Look for tax-conscious fund managers.

Tax-conscious fund managers (like those at Dimensional Fund Advisors, Avantis Investors, or Vanguard) understand how taxes work and will go to great lengths to make sure you as the end investor pay the least amount of tax possible.

6. Choose tax-free funds.

While this sounds appealing, the only way to avoid tax on mutual funds altogether is to invest in a tax-free municipal bond fund. If you are a Maryland resident and you owned a Maryland municipal bond fund, for instance, the income generated would be free from both federal and state taxes.

Pay Less Tax On Mutual Funds

The bottom line is that the better you understand how your money is invested by a mutual fund, the better you’ll fare tax-wise. We recommend working with a professional for the best tax-saving results. A financial advisor can do the homework of figuring out how a fund is invested, seeking to understand your investment goals, and picking the right funds to align with your objectives.

At Bay Point Wealth, we can help you hold various investments in diversified places, such as taxable accounts vs. an IRA, to make your portfolio as tax-efficient as possible. Our team can also help you tax-loss harvest, and will proactively reach out to you when there’s an opportunity to do so. If you want to learn more about our tax-focused approach to investing, schedule a call with us today.

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Topics: Financial Planning, Wealth Management