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| Taxes and Funds:
Uncle Sam's Share |
| Getting a check
from the mutual funds you hold outside your employer
retirement plan or IRA might seem like a great thing.
But in fact, it's a good news, bad news situation.
The good news: You've made some money. The bad news:
So has Uncle Sam. |
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Investors in conventional mutual funds can get stuck
with a tax bill on their mutual fund holdings, even
if they've lost money since they've held the fund.
Like all investors, fund investors have to pay taxes
on dividends from stocks and interest from bonds, and
they also have to pay taxes on all fund distributions,
including capital gains, which occur when a fund manager
sells an underlying holding for more than its purchase price.
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| So even if you're a buy-and-hold
investor, you'll probably still have to pay taxes
on your funds each year, whether or not you reinvest
your payments back into the funds. And, unfortunately,
you have no control over when or how much a mutual
fund might pay out. |
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To minimize the tax bite in taxable accounts, consider looking
for funds that don't pay out a lot of dividends or capital gains.
One of the best ways to do that is to look up your fund on Morningstar.com
and click on the Tax tab on the navigation bar at the top of the page to
get a glimpse of that fund's tax profile. Generally speaking, there are
two types of funds that tend to be tax-friendly. Large-cap index funds
(such as S&P 500 index funds) are great for accounts outside your DC plan or
IRA, because they rarely sell stocks—meaning they rarely pay out taxable capital
gains Additionally, funds with turnover rates of less than 25% a year are
generally considered fairly tax-efficient.
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Another option are tax-managed funds, which try to keep income and capital
gains to a bare minimum. You also may want to look at index funds, which
are passively managed funds that try to match the returns of the market index
and make portfolio changes only when the index constitutes a change. A manager
in active manager fund generally trades a lot more than index fund as his or
her strategy is to try to beat the market.
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But don't go too far in your quest for tax-efficiency-after-tax returns
are what matter most. You may be better off in a tax-inefficient fund
with great returns than in a fund that's highly tax-efficient but with
lower returns. |
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