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.