Many mutual fund investors (and investors in general) send
a good portion of their profits to the IRS as well as to
state and local tax collectors. Fortunately, a knowledge
of the rules and some savvy planning can help you keep
more of your investment income for yourself.
If you invest outside of a retirement plan and put your
money into mutual funds, you’ll owe tax each year on net
earnings realized by the fund. That’s true even if you hold
onto your fund shares and reinvest all the distributions.
Suppose, for example, you put your money into a mutual fund
and the manager decides to sell many of the fund’s long-term
holdings, which generates a gain. That gain will be passed
through to you, as a shareholder, and you’ll owe tax right
away, even if you instruct the fund that all distributions
are to be reinvested.
Therefore, if you’re going to sell a fund at a loss, sell
before it makes a capital gains distribution, because your
tax loss will be greater. Similarly, try to avoid buying a
fund before right before a distribution, because you’ll
receive that distribution and owe taxes. Most funds will
tell callers when distributions can be expected.
Another tactic is to buy a “tax-managed” mutual fund. Funds
that are intentionally tax-efficient usually avoid taxable
distributions by low turnover of their securities or by
taking losses to offset realized gains.
