Got mutual funds in your regular taxable account? You can potentially get taxed either because of what the fund does or because of what you do.
Let’s start with the former. Each year, a mutual fund is required by law to distribute virtually all of the interest and dividends that it earns, as well as any realized capital gains. Those are bundled together into periodic income and capital gains distributions. When these distributions are made, a fund’s share price drops by a comparable amount, so investors are no better off in terms of their pretax wealth. Nonetheless, taxable shareholders have to pay taxes on these distributions.
Bond and money-market funds typically pay income distributions every month, while stock funds might hold off until the end of year and then make a single set of distributions. If you own a fund when those distributions are made, you have to pay taxes on the sums involved, even if you only just bought the fund shares and even if you opt to reinvest the distributions back into the fund. For that reason, taxable account investors are often cautioned against making big stock mutual fund investments right before year-end.
Want to hold down the tax bill that your funds generate? In your taxable account, you might favor stock funds that pursue a buy-and-hold strategy, such as index mutual funds, exchange-traded index funds and tax-managed funds. These funds are typically slow to realize their capital gains—and, when they do, the gains are usually taxable at the long-term capital gains rate. By contrast, many actively managed stock funds have portfolio turnover of around 60% or 70%, which means they’re typically holding shares for roughly 18 months.
While buying tax-efficient funds can help, you also need to temper your own behavior. In other words, even if your funds don’t make big taxable distributions, you can end up with big tax bills if you’re too quick to sell your funds. A silver lining: When you sell a fund, your cost basis for tax purposes includes not only the amount you invested, but also any distributions you reinvested in additional fund shares.
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