One of the greatest attributes of mutual funds is simplicity. But leave it to the complexity of taxation to screw things up.
Some of the most common tax mistakes happen with mutual funds. But by revisiting some of the basics of mutual fund taxation, you can avoid those big mistakes and possibly improve your portfolio returns.
The first thing to keep in mind is that mutual funds are not the same as other investment securities. For example mutual funds are pooled securities; a single portfolio may hold dozens or hundreds of other securities, such as stocks and bonds.
Taxes Are Most Commonly Generated by the Fund’s Activities, Not Yours
It is also important to remember that the mutual fund investor does not have any real control over the management of the portfolio and that the taxes generated by the underlying holdings or by the activity of the fund’s manager are passed along to the investor.
This, of course, assumes that the fund is held in a taxable account and not a tax-deferred account, such as an IRA or 401(k).
For example, if during the course of a single tax year, some stock holdings in your mutual fund pays dividends, and the fund manager sells some of the stocks at a higher price than that of the their purchase price, you’ll owe tax on two levels: 1) A dividend tax, which is generally taxed as income, and 2) A capital gains tax, which will be taxed at capital gains rates.
And even if you’ve only held the mutual fund for a few months and have not sold any shares of the fund, it is possible that you could receive a long-term capital gain distribution (assuming the mutual fund held the stock for more than a year).
Therefore, the taxes distributed to you, the investor, are due to the activities within the mutual fund, not due to your own investing activities.
Tax Mistakes: Double-Paying Mutual Fund Taxes
Let’s assume you sell your mutual fund in your taxable account after three years. And let’s also assume that your original investment was $10,000 worth of shares in the mutual fund and it had paid $500 in dividends per year for all three years. And because you didn’t need the income and you had a growth objective, you elected to have all dividends reinvested to buy more shares of your mutual fund.
You chose a top-performing fund during a bull market and the fund’s price appreciation, including dividend reinvestment, gives you a final value of $15,000 when you go to sell your mutual fund. Not bad for 3 years!
Since you bought the fund at $10,000 and you sold it at $15,000, you will pay tax on $5,000 in long-term capital gains, right? If you are like millions of other investors who make the same mistake each year, you might say “yes.” But you would be wrong and thus would be paying too much in taxes!
Why? Remember, your original investment was $10,000 but you also invested (or rather re-invested) $1,500 ($500 x 3 years) in dividends. Therefore your basis is $13,500 and your taxable gain is $3,500 (not $5,000)!
The example here is simplified and does not account for compounding interest but the lesson remains the same: It is easy to make the tax mistake of thinking that the original amount invested is the “basis” for tax reporting. But the IRS says all reinvested dividend and capital gain distributions count as “investments,” too.
Tax Mistakes: Location, Location, Location!
Perhaps the most common of tax mistakes is simply mismatching fund types with account types. This is something I call asset location, though other investment advisers and financial planners may call it tax alpha. Either way, it’s a case of managing tax-efficiency.
Tax efficiency is a measure of how much of an investment’s return remains after taxes are paid. Put simply (and all other things being equal), the greater the tax efficiency, the higher the net return after taxes. The opposite is true, too: Tax inefficiency is a drag on performance.
There are three basic ways to succeed at tax-efficiency, to achieve the greatest tax alpha:
- Asset Location: If you have a tax-deferred account, such as an IRA or 401(k), and you also have a taxable account, such as an individual brokerage account, try to concentrate the income-generating investment types, such as bond funds and dividend-paying stock funds, in the tax-deferred account.
- Fund Selection: In your taxable account, try to use tax-efficient funds, such as stock index funds and municipal bond funds (best for investors in high federal income tax brackets).
- Tax-Loss Harvesting: Whenever possible, and if appropriate for your investment objective in your taxable account, try to periodically sell securities in such a way where you can offset capital gains with capital losses.
On a final note, each individual case is different and careful planning is crucial before implementing tax strategies. You may also refer to IRS Publication 550 once per year to stay on top of tax basics and any new rules that can be used to your benefit.
Kent Thune provides this information for discussion purposes only, and should not be misconstrued as tax advice or investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.
