Tax Strategies for Mutual Fund Investing

Some investors make the mistake of selecting mutual funds for investment based solely on advertised returns. The problem with this approach is that many funds pay out all or a portion of earnings to the fund shareholders and these distributions are subject to taxation. This can dramatically reduce your actual return. The good news is that fund companies are required by law to provide investors with the after-tax return information within their fund prospectus. The wide selection of mutual fund investments available today enables the investor to shop around in search of funds that offer the best after-tax returns.

Researching Mutual Fund Investments Based on Tax Liability

When choosing among mutual funds (for investment outside of retirement accounts) based on after-tax return, the factors to consider include:

Fund Holdings: The securities held by the fund will impact your tax liability. For example, income-producing funds will make regular distributions to that are taxed as ordinary income. Alternatively, if the fund invests mainly in low-yield growth stocks, there are likely to be fewer distributions and less of a tax consequence.

Turnover Rate: The fund’s “turnover rate” or “turnover ratio” provides an indication of how frequently the fund is buying and selling securities. High turnover can present significant tax consequences to the fund shareholders. The best use of the turnover ratio is in comparing funds with similar investment objectives. Many investors look for a turnover ratio of 20% or less when considering tax-efficiency as part of their fund selection criteria.

Screen for mutual funds by turnover ratio

Tax-Friendly Mutual Fund Choices

Index Funds: An index fund is a type of mutual fund that tracks the components of a market index. These funds are more passively-managed than more traditional funds and usually offer very low turnover rates. In general, these types of funds are worth considering for most investors because the majority of mutual funds fail to outperform broad indexes, like the S&P 500.

Tax-Managed Funds: Many mutual funds are constructed and managed with the specific goal of minimizing tax consequences to the fund shareholders. Managers of these funds will, for example, look to offset taxable gains by harvesting losses at appropriate times. These funds also tend to look for stocks with low dividend yields.

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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

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