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Minding the Tax Bite in Mutual Fund Investing

Minding the Tax Bite in Mutual Fund Investing

How painful was tax season for you?

For many investors with mutual funds in a taxable account, it was tougher this year than last. That’s because the best year for stocks since 1997 pushed many funds to make capital gains distributions to their shareholders, and those
got taxed even if the shareholder didn’t sell any shares. Investors who make the biggest incomes got a double whammy: They paid a higher percentage of their capital gains distributions in taxes than a year before.

 

Now that April 15 has passed, investors have a chance to reflect on what drove their tax bills and rejigger their portfolios. For most retirement investors, the answer is simple: Keep your mutual funds in a tax-advantaged account, whether that’s a 401(k), individual retirement account or Roth IRA. For those with funds in taxable accounts, other avenues are available for tax-smart investing, and experts say they’re growing in importance.

During the ‘80s and ‘90s, when markets were booming, many investors were making so much money that they didn’t mind paying big tax bills, says Fran Kinniry, a principal in the investment strategy group at Vanguard. Now that many don’t expect the returns they got during the boom years, there’s more interest in keeping costs and taxes low.

“Investors are taking 100 percent of the risk of their investments, and the goal should be to capture as much as 100 percent of that return,” Kinniry says.

First, a reminder on the taxes mutual-fund investors can incur: Funds that own dividend-paying stocks distribute those payments to shareholders, which can be taxable. Each year, funds also tally the gains booked from selling stocks and bonds. From that, funds subtract the losses they incurred from trading and pass along the remainder to shareholders. These are called capital gains distributions, and the tax rate on long-term gains for the very top earners rose to 23.8 percent last year from 15 percent.

Here’s a look at what investors can do to minimize those payments:

— REMEMBER THE POWER OF TAX-ADVANTAGED ACCOUNTS. If you own a mutual fund in a 401(k) or IRA, you also get dividend and capital-gains distributions. But you don’t need to worry about taxes until you withdraw money. Investors with funds in a Roth IRA don’t need to worry about taxes on those distributions at all, under some conditions.

Tax-advantaged accounts are particularly useful for mutual funds that produce more distributions than others, such as ones focused on bonds, dividend-paying stocks or real-estate investment trusts. Actively managed stock mutual funds - ones run by stock pickers looking to beat an index - also can have bigger gains distributions because they do more buying and selling than index funds.

— SOME MUTUAL FUNDS ARE BUILT TO MINIMIZE TAXES. Tax-managed mutual funds use several methods to limit their shareholders’ tax bills. They can be biased toward stocks with lower dividend yields, looking to limit dividend payments, for example. They also try to hold off on selling stocks to minimize potential capital gains distributions.

Generally, only investors who have already maxed out their annual contributions to tax-advantaged accounts like IRAs would consider tax-managed funds. Because their audience is so narrow, they tend to have fewer assets under management, says Michael Rawson, a fund analyst at Morningstar.

Their smaller size means tax-managed funds don’t benefit from the economies of scale that large mutual funds do, which can mean higher expense ratios, Rawson says.

— INDEX FUNDS AND ETFs CAN MEAN SMALLER TAX BILLS. The capital-gains distributions that funds make are a result of buying and selling stocks. So one way to limit those distributions is to limit buying and selling.

Big index mutual funds and ETFs do just that. Unlike actively managed funds looking to beat the market, index funds are merely trying to match an index’s performance. That means they’re content to own the same stock as long as it stays in the index. Index funds also tend to have lower expenses than actively managed funds.

But “just because a fund is an index fund doesn’t mean that it’s tax efficient,” says Vanguard’s Kinniry. Indexes that cover smaller swaths of the market tend to change more often than large, broad-market indexes. So a small-cap value index fund will likely see more turnover than a broad-market index fund, which can trigger more gains distributions.

 

 

 

Minding the Tax Bite in Mutual Fund Investing, April 28, 2014, LegalNews.com

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