Mutual Funds and ETFs (exchange-traded funds) are popular investment vehicles, both for seasoned investors and those just starting to build a portfolio. By combining money with other investors, and either allowing the leadership of a professional fund manager (active investor) or the stability of larger indexes (passive) fuel growth, these funds can efficiently provide investors access to almost the entire investable world.
That stated, there are tax implications and tax reduction strategies every mutual fund investor should be aware of. Mutual Funds will pay out 95% of all realized net capital gains annually, generally late in the year. And these gains are taxable for the current year. This is especially problematic in active funds, where trades are far more prolific.
As the trusted physician retirement planning company in Canyon County, and surrounding areas, we urge our clients to keep these few points and strategies in mind when investing in mutual funds.
1. Taxes on Capital Gains are a Given, Except…
You can avoid the capital gains, dividend, and income taxes by keeping mutual funds in a tax-deferred investment vehicle, such as a 401k or IRA.
This is a pretty fundamental strategy, but it is worth noting for those who are starting out. Tax-deferred growth in one of these vehicles is a huge advantage. It allows you to continue to accumulate interest on the assets you would have otherwise paid tax on, making your assets grow faster.
If you invest through a 401k, IRA, etc., your tax issues are solved while the money stays there. If you invest in a taxable way, however, keep reading.
2. For Active Traders: Sell Before Distribution
If you are an active trader and hold assets in a taxable account, make sure to research the fund’s distribution timeframe. Then sell beforehand. However, we’re not big fans of this strategy unless the capital gains tax bill is really going to be an issue.
IMAFS also does not recommend the wanton buying and selling for the sake of percentage points. A conservative buy and hold of a well-performing fund is usually a better strategy regardless of taxes, as it allows investors to take advantage of long-term compounding returns, which is the real source of growth over time. You must also keep in mind that due to IRS rules, if you sell a fund, you cannot buy it back until 30 days later, so selling just to avoid the distribution may not be that advantageous.
3. For Active Traders: Buy After Distribution
Again, this makes great sense for active traders. There’s no sense in buying a fund two weeks before a large capital gains distribution when it’s just as easy to buy it the day after. Then you have an entire year of growth before this is an issue again.
Obviously, this is something to be more mindful of in active funds rather than passive ones.
4. Choose tax-efficient funds
Huge variety exists in mutual funds and ETFs, but there are two broad categories to be aware of: active and passive. Passive funds seek to track an entire marketplace, so a much smaller percentage of their assets are bought and sold each year, on average. Active funds actively seek to outperform their benchmark, and thus typically buy and sell more often than their passive counterparts, resulting in a greater tax impact. Within these categories, tax efficiency can still vary widely by fund, depending on management style, so make sure to do your research.
5. Tax Loss Harvesting
Your losses elsewhere can offset taxes on capital gains. While you shouldn’t invest in order to create losses, you will certainly end with some from time to time. Whenever you sell a position at a loss relative to your cost basis, you can claim that loss to offset a gain somewhere else in your portfolio. While wash sale rules prevent selling at a loss and then buying it again right after, there is nothing against switching to a very similar asset, say from the Fidelity 500 Fund to the Vanguard Institutional Index. You functionally own the exact same thing, and you get the benefit of the tax loss. It’s called Tax Loss Harvesting, and it’s a great strategy for opportunistic investors.
6. Lastly, Mindset Matters
Make sure you talk to your tax advisor about how to improve the tax efficiency of your portfolio without materially hurting your investment strategy. At IMAFS, we combine academically sound investment practices with a sharp focus on tax strategy to create the most efficient wealth management portfolios for physicians in Ada County and beyond.