How Tax Efficient Is Your Mutual Fund?


Although investing can be a great way to generate income, your earnings are likely to be subject to income tax like any other type of income. Mutual funds are a popular investment option for many reasons, but they can actually create a significant tax burden in some cases. Because individual investors do not have any control over the investment activity of a mutual fund, it is important to ensure that your mutual fund is tax-efficient.

There are a number of factors that dictate the tax efficiency of your mutual fund, including the frequency of business activity, the longevity of each investment in the portfolio, and the types of distributions your fund makes.

Key takeaways

  • Mutual funds with lower turnover rates (and assets that are at least one year old) are taxed with lower capital gains rates.
  • Mutual funds with dividend distributions can generate additional income, but are also typically taxed at the highest ordinary income tax rate.
  • In certain cases, qualified dividends and mutual funds with investments in government or municipal bonds may be taxed at lower rates or even tax-free.

Mutual Fund Income: The Basics

The tax efficiency of a mutual fund depends on the type of exclusive distributions from that fund. To avoid paying corporate income taxes on your earnings, mutual funds must distribute all of their net earnings to shareholders at least once a year. This distribution falls into one of two categories: dividend distributions or capital gains distributions.

Dividend distributions occur when your existing fund receives a payment in dividend-generating stocks and interest-bearing bonds. Rather, capital gain distributions are generated when the fund manager sells the fund’s assets for a net profit. For example, if the fund invested $ 100,000 in one share and then sold all of its shares for $ 110,000, the 10% gain is considered a capital gain.

Mutual fund taxation

Depending on how long your fund has held its assets, the income you receive from a mutual fund may be taxed like ordinary income or capital gains. This can be a source of confusion because not all capital gains distributions are taxed at the capital gains rate.

Unlike investing in individual stocks, applying the capital gains tax rate has nothing to do with how long you’ve had stocks in a mutual fund, but how long the mutual fund has held the assets in your fund. purse. Only earnings from assets the fund has held for a year or more are taxed at its capital gains rate, rather than its ordinary income tax rate. Meanwhile, dividend distributions are generally taxed at the ordinary income tax rate, unless they are considered qualified dividends.

Differences in fund tax rates

Capital gains tax rates are always lower than the corresponding income tax rates, although the difference between these two rates can vary. People who earn less than $ 80,000 are not required to pay any taxes on their capital gains. Those who earn up to $ 441,450 are subject to a 15% capital gains tax, while those who earn more must pay a 20% capital gains tax.

For example, suppose you earn $ 80,000 and receive $ 1,000 in investment income from the sale of stocks. If you’ve held the investment for a year or more, you only have to pay 15%, or $ 150, in taxes. However, if it is a short-term profit, you must pay $ 280.

Mutual funds taxed at the capital gains tax rate will always be more tax efficient than mutual funds taxed at the ordinary income tax rate.

Tax efficiency factor: asset turnover

One of the most effective ways to create a more tax efficient mutual fund is to lower your turnover rate. A fund’s turnover ratio refers to how often the fund buys and sells securities. A fund that executes many operations throughout the year has a high asset turnover. The result is that most of the capital gains the fund generates are short-term gains, which means they are taxed at the ordinary income tax rate.

Funds that employ a buy-and-hold strategy and invest in growth stocks and long-term bonds are generally more tax efficient because they generate taxable income at the lowest capital gains rate. When a fund distributes capital gains, it will issue you a Form 1099-DIV that describes the amount of the distribution attributable to long-term gains.

Very active mutual funds also tend to have higher expense ratios, or the amount of money the fund charges each year to maintain itself and cover administrative and operating costs. Although this doesn’t have a huge impact on your annual taxes, it can be a substantial drain on your finances.

Tax efficiency factor: dividends

If your mutual fund contains investments in dividend-paying stocks or bonds that pay periodic interest, called coupon payments, you will likely receive one or more dividend distributions per year. While this can be a convenient source of regular income, the benefit can be offset by the increase in your tax bill.

Most dividends are considered ordinary income and are subject to your normal tax rate. Non-dividend mutual funds are therefore naturally more tax efficient. For those whose investment goals are geared toward increasing wealth rather than generating regular income, investing in dividend-producing stock-free funds or coupon-bearing bonds is a smart and tax-efficient measure.

A middle ground: qualified dividends

Some investors consider dividend distribution to be one of the main benefits of fund ownership, but still want to reduce their total tax burden as much as possible. Fortunately, some dividends can be considered “qualified dividends” and be subject to the lower tax rate on capital gains.

For dividends to be considered qualified, they must meet certain criteria, including a holding period requirement. Qualified dividends must be paid by an eligible US or foreign corporation and purchased prior to the ex-dividend date. The ex-dividend date is the date from which subsequent share purchases are not eligible for the next dividend. Stock must have been held for at least 60 days within the 121-day period beginning 60 days prior to this date.

Like capital gains, whether your dividends are deemed qualified has nothing to do with how long you’ve owned shares of a mutual fund, but rather how long the fund has owned shares of the dividend-paying stocks and when those shares were purchased. Even if you buy shares in a mutual fund tomorrow and receive a dividend distribution next week, that dividend is considered qualified on the fund as it meets the holding requirement above.

Again, mutual funds that employ a buy-and-hold strategy are more tax efficient, as they are likely to generate qualified dividends as well as long-term earnings. Funds that distribute qualified dividends report them on Form 1099-DIV, as do long-term capital gains.

Fiscal efficiency factor: tax-free funds

Another way to optimize a tax-efficient mutual fund is to choose funds that include investments in government or municipal bonds, which bear interest not subject to federal income tax. Some funds invest only in these types of securities and are often called tax-free funds.

Even if your mutual fund is not a tax-free fund, funds that include some of these types of securities are more tax efficient than those that invest in corporate bonds, which earn taxable interest subject to your tax rate. on ordinary income.

To dig a little deeper, some municipal bonds are actually more tax-free than others. While all are exempt from federal income tax, some bonds are still subject to state and local taxes. However, bonds issued by governments located in your state of residence may be triple tax-free, which means they are exempt from all taxes.

If you’re looking to invest in mutual funds or simply re-evaluate your current holdings, examine each fund’s portfolio to make sure your investments don’t end up costing you at tax time. To optimize the tax efficiency of your mutual fund, choose funds with low turnover rates that include non-dividend stocks, zero coupon bonds, and municipal bonds.

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Mark Holland

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