Taxes & Insurance

If you’re going to sell a fund at a loss, sell before it makes a capital gains distribution. Image: Mr Doomits/Shutterstock.com

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 an actively managed mutual fund and the manager decides to sell some 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.

Also consider these strategies for investing outside of tax-favored retirement savings programs:

* Tax-managed funds: A number of mutual funds have “tax-managed” in their names. These funds attempt to take losses to offset gains so that no net gains are passed through to investors. If they must take gains, they try to hold stocks for a year or longer before taking profits, in order to qualify for low-taxed long-term gains.

* Index funds: These funds track an index such as the Standard & Poor’s 500. They generally do little trading so they may not realize gains that have to be passed through to investors.

* Exchange-traded funds (ETFs): These are index funds that trade like stocks. They enjoy special tax code treatment so they may be even more tax-efficient than index mutual funds.

In many cases, index mutual funds and ETFs also have low expenses in comparison with actively managed funds. This can boost the returns investors enjoy, over the long-term.

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