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Three Mutual Fund Tax Essentials


What you need to know to about tax-efficient investing

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Mutual funds offer investors a host of benefits. They don’t require large upfront investments, they’re easy to buy and sell and they’re professionally managed or overseen. But it’s also important to be aware of the tax implications of funds you choose—especially if you hold them in a taxable brokerage account. (Tax-deferred accounts, like IRAs and 401(k)s, shield you from any immediate tax burden.)

“Taxes create a drag on returns, so any time your investments incur taxes, you want to make sure to minimize or reduce that drag,” says Andrew Zumwalt, an assistant professor in the University of Missouri’s department of personal financial planning.

Here’s what you need to know about the tax ramifications of investing in mutual funds.

1. Understanding mutual fund taxes. When a mutual fund sells securities for more than it initially paid, the fund realizes capital gains. If those gains are not offset by realized losses, the gains are passed on to investors, who must then pay taxes on that income. Short-term gains (incurred for stock held less than one year) are taxed as regular income tax rates. Long-term gains qualify for a (usually) lower capital gains tax rate. The rate varies from zero to 20 percent, depending on your tax bracket.

Funds typically distribute gains or losses at the end of the year. If you own a fund when its capital gains are distributed, you’ll owe taxes—even if you hadn’t yet bought shares when the gains occurred.

Mutual fund managers must also distribute income, such as dividends, generated by the fund’s underlying securities. These dividends are taxed either as ordinary income or, if they meet certain criteria, are taxed at your capital gains rate. Don’t worry about keeping track of all these numbers:  Your brokerage or mutual fund company will provide that information to you on Form 1099-DIV, which is mailed by February 15 each year.

2. Investing tax efficiently. The key to minimizing taxes on investments is holding each type of security in the type of account that is most appropriate. Consider these guidelines:

  • Tax-advantaged accounts: Best for funds that buy and sell shares frequently, such as many actively managed mutual funds.
  • Taxable accounts: Best for funds that trade relatively infrequently and thus realize few capital gains. Index funds, like those that track the S&P 500, typically fit this description.

3. Tax-managed funds. Some mutual funds are managed specifically with an eye toward minimizing taxes. Tax-managed funds use strategies to avoid generating large capital gains. For example, if the manager of a tax-efficient fund sells a security with a large capital gain, he or she may try to offset that gain by selling a security that has a large realized loss. Because these funds are structured to minimize investors’ tax bills, they are best held in a taxable investment account.

Understanding the impact of your investments on your tax situation can be challenging.  A SunTrust financial advisor can help you maximize your portfolio’s tax efficiency and help you meet your financial goals.


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