How to Legally Avoid Capital Gains Tax on Mutual Funds

how to avoid capital gains tax on mutual funds

how to avoid capital gains tax on mutual funds

In the long run, if you sell an investment asset for a profit you will owe capital gains taxes. But for active investors, it’s important to understand that the IRS gives you a few ways to defer those taxes. This kind of tax planning can be particularly useful with more complicated products like a mutual fund. If you’re looking to avoid getting hit with a tax bill the next time you move money around, here are some ways to manage your assets.

For proper tax planning to get ahead of any potential liability, you can also work with a financial advisor who specializes in tax.

Capital Gains Taxes and Mutual Funds

Mutual funds are a popular investment vehicle because of the balance they can potentially bring to your portfolio. Not everyone thinks about the potential tax consequences of investing in a mutual fund before taking the plunge but it’s important to understand before you invest. There are two main ways that you pay taxes on a mutual fund.

  • Ordinary Income Tax: If you have an income-generating fund, you might pay ordinary income taxes on the money the fund distributes. Yields such as interest and non-qualified dividends are taxed as ordinary income for the year in which you receive them, and many mutual funds generate those payments.

  • Capital Gains: The much more common way is through capital gains taxes. You owe capital gains taxes on the profit that you make whenever you sell an investment asset or receive qualified dividend payments. So, for example, say you bought into a mutual fund at $100 per share and you sold it for $150. You would owe capital gains taxes on the $50 of profit that you collected from that sale.

You can also owe capital gains taxes based on the fund’s activity. A mutual fund is a portfolio of underlying assets. Each share represents a percentage of ownership of those assets as a whole. When a mutual fund sells assets in its portfolio for a gain it can, under most circumstances, do one of two things. Sometimes the fund will reinvest the proceeds in new assets. Other times, however, the fund will pass the proceeds from any sale back to its investors on a per-share basis in what is known as a “capital gains distribution.”

In most, if not all, cases, when a mutual fund is competently managed you will not see any tax consequences from a reinvestment. However, if you receive a capital gains distribution you may owe capital gains taxes on that money. This is how mutual funds can cause tax events for their investors even if you don’t sell a single share.

How To Manage Mutual Fund Capital Gains Taxes

how to avoid capital gains tax on mutual funds

how to avoid capital gains tax on mutual funds

So how can you manage capital gains taxes on your mutual funds? There are a few ways that you can go about it, including:

1. Hold Funds in a Retirement Account

The easiest way to manage any form of capital gains tax is to hold your investments in a qualified retirement account. As a general rule, the IRS does not consider the sale or management of these assets a tax event until you make a withdrawal from the account.

This means you can sell shares of your mutual fund or collect a capital gains distribution without paying the relevant taxes so long as you keep the money in that retirement account. You will ultimately owe any related taxes once you withdraw the money, of course.

2. Capital Gains Distribution

Outside of a qualified, tax-advantaged retirement account, there’s not a whole lot you can do to avoid taxes on a capital gains distribution once it has been made. Generally speaking, the best way to manage taxes on capital gains distributions is to avoid incurring them.

Look for funds that have a low turnover rate. This means that they tend to sell and move assets less frequently than other funds. The longer a mutual fund holds its assets, the less often it will generate sales and distributions. Also, look for funds that tend to reinvest profits rather than issuing distributions. Again this will often, but not necessarily always, allow you to avoid tax events. Index funds often manage assets this way, so they’re a good place to start.

3. Long-Term Capital Gains

While this is true of all investment assets, not just mutual funds, try not to sell assets that you have held for less than a year. If you sell something within a year of purchasing it, this is considered a short-term investment and is taxed at the rate of ordinary income. If you sell something after holding it for a full year, it is taxed at a considerably lower capital gains rate.

4. Manage Shares

When you sell shares of a mutual fund or any investment asset at all, your profit is calculated based on what you paid for the underlying asset. As in our example above, if you buy shares of a mutual fund for $100 and sell them for $150, you will be taxed on the $50 difference.

But, say that you’ve invested in this mutual fund over time, paying different amounts for your shares with each investment. In that case, you can choose to specify which shares you have decided to sell, and your taxable profits will be based on that difference.

For example, say you bought three shares in a mutual fund, paying $100, $120 and $140 for each share (respectively). You now sell one share for $150. No matter which shares you sell, you will collect the $150. But if you specify that you sold the most recent share, you will only owe taxes on $10 worth of capital gains ($150 sale price – $140 purchase price).

Now, this kind of management has a catch. Ideally, your fund will continue to grow, which means that you will owe that much more in taxes once you do eventually sell the $100 and $120 shares. However, if there’s value in managing your cash flow this way, it is a valid tax planning tool.

5. Tax-Loss Harvesting

Finally, many investors employ a tool called “tax loss harvesting” which can be tricky. Capital gains taxes are based on net profits over the course of the year. This means that you add up all of your profits from selling profitable investment assets, subtract all of your losses from selling unprofitable investment assets, then pay taxes on the final amount.

This means that you can sell some assets for a loss in order to reduce your total capital gains for a given year. For example, say you have the $50 gain from selling a share of your mutual fund. Say you also have a stock that is currently worth $20 less than you bought it for. You can sell that stock before the end of the year, realizing a $20 loss. This would partially offset the gain from your mutual fund, bringing your total taxable gains down to $30.

The problem with tax loss harvesting, of course, is that it means taking a loss. This strategy is generally a good idea if you have investments that you were going to sell anyway. It’s not worth liquidating a good investment early just for the tax break. It can be worthwhile, though, to time your exit from a bad investment if it can help you offset taxes elsewhere.

The Bottom Line

how to avoid capital gains tax on mutual funds

how to avoid capital gains tax on mutual funds

There are two main ways you can get taxed on a mutual fund: by selling your shares or by collecting a capital gains distribution. While you can’t defer taxes on those gains entirely, you can manage them in a few different ways that we’ve described above. The important thing is to understand how you might be taxed so that you can properly plan for any tax that you may owe, depending on what you want to do with your investments. 

Tips for Tax Planning

  • For many investors, mutual funds are an excellent way to balance diversification with gains. But are you one of them? SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

  • We have gone into even more depth on how all of this may work for you in our deep dive into how taxes work with mutual funds.

©iStock.com/Mrinal Pal, ©iStock.com/nuttapong punna, ©iStock.com/Kurgenc

The post How to Avoid Capital Gains Tax on Mutual Funds appeared first on SmartAsset Blog.

Source: https://finance.yahoo.com/news/legally-avoid-capital-gains-tax-130037703.html