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Taxes can be complicated, and for investors in mutual funds, they can be extremely complicated. There can be taxes on dividends and earnings when you own mutual fund shares, in addition to capital gains taxes when you sell your shares in the fund. You don’t even have a say in when to realize a gain in the fund’s holdings because that decision is made by the fund’s manager on behalf of all shareholders.
But once you break things down into the different types of taxes, it’s actually fairly straightforward. Here are the key mutual fund taxes to be aware of and some strategies for how to minimize those taxes.
Mutual fund taxes
Mutual funds can be a great choice for investors because they allow you to hold a diversified portfolio of securities for a relatively small investment. But investing in mutual funds means you don’t have control over the individual holdings in the fund, which is chosen by the fund manager. The fund’s price, or net asset value (NAV), will rise and fall based on the performance of the underlying holdings in the fund.
Even when you still own the fund, taxes on mutual fund shares can be triggered in two ways:
- Dividends and interest: If the fund holds securities that pay dividends or interest, the fund will distribute your share of those payments to you, and you’ll owe taxes on that income. Some mutual funds, such as municipal bond funds, focus on investments that are exempt from federal income tax. If you do receive dividends or interest from a fund you hold, you’ll likely receive an IRS tax form that shows your income from the fund for the year. The form may come from the fund company itself, or from your online broker.
- Capital gains: The fund manager may sell securities in the fund for a profit, triggering a capital gains tax. The tax impact will depend on how long the fund held the shares that were sold. The capital gains are distributed, typically once a year, to the fund’s shareholders, who will owe taxes on the gains.
For more details on the taxation of investment income, check out IRS Publication 550.
If the securities held in your mutual fund perform well, the fund’s NAV will appreciate, giving you a gain on your original purchase. You’ll need to pay taxes on this gain, but figuring out exactly how much you owe can be complicated.
If you bought your shares all at once, the calculation will be relatively simple. You subtract the price you paid per share from the price you sold at and the difference equals your per-share gain. But most people buy mutual funds consistently over time, meaning you will have paid several different prices for your shares. You can either use the average cost of all the shares you own to calculate your gain, or you can use specific shares with a specific cost basis.
It also matters how long you’ve held your shares. If you’ve owned the shares for more than a year, you may get a break on the capital gains tax rate because the gain is considered long term. For gains on shares held less than one year, you’ll pay taxes at the ordinary income rate.
How to minimize taxes on mutual funds
Taxes on mutual funds are a sign that you’ve either received some form of investment income or you’ve realized a gain, so they’re not all bad. But avoiding taxes can help you achieve higher long-term returns. Here are some of the best ways to minimize taxes on mutual fund investments:
- Hold shares in tax-advantaged accounts: One of the easiest ways to avoid taxes on mutual fund investments is to hold the shares in tax-advantaged accounts such as a 401(k) or a traditional or Roth IRA. Your investments will be allowed to grow tax-free, meaning you won’t pay taxes on the distributions you receive or gains you realize. You won’t pay taxes on withdrawals either, in the case of a Roth IRA.
- Hold funds for the long term: By holding funds for more than one year, you’ll be able to pay taxes at the long-term capital gains rate, which is a major advantage for most investors.
- Avoid certain types of funds: If you want to avoid taxes, you’ll probably want to steer clear of funds focused on dividends or funds with high portfolio turnover, both of which can cause a lot of realized gains. Index funds may be your best bet, because they typically pay modest dividends and have low turnover.
- Tax-loss harvesting: Using a tax-loss harvesting strategy involves selling some investments at a loss to offset your gains, allowing you to pay less in taxes.
You can also limit your tax exposure by holding exchange-traded funds (ETFs) instead of mutual funds. ETFs often hold similar investments to their mutual fund counterparts, but aren’t required to distribute realized capital gains, making them more tax efficient.
Bottom line
Taxes on mutual funds can be complicated because you can be taxed on dividends and the fund’s gains even before you’ve sold your shares. Of course, you’ll also be taxed on any gain in the fund’s value when you decide to sell. The simplest way to avoid this is to own mutual funds in tax-advantaged retirement accounts such as IRAs and 401(k)s. You can also make sure to hold the investments for the long term, so that if you do owe taxes, you’ll pay them at the lower long-term capital gains rate.
FAQs
The simplest way to avoid this is to own mutual funds in tax-advantaged retirement accounts such as IRAs and 401(k)s. You can also make sure to hold the investments for the long term, so that if you do owe taxes, you'll pay them at the lower long-term capital gains rate.
How to minimize taxes on mutual funds? ›
The simplest way to avoid this is to own mutual funds in tax-advantaged retirement accounts such as IRAs and 401(k)s. You can also make sure to hold the investments for the long term, so that if you do owe taxes, you'll pay them at the lower long-term capital gains rate.
How are taxable mutual funds taxed? ›
Like income from the sale of any other investment, if you have owned the mutual fund shares for a year or more, any profit or loss generated by the sale of those shares is taxed as long-term capital gains. Otherwise, it is considered ordinary income.
How does mutual fund save tax? ›
ELSS mutual funds allow you to save tax under Section 80C of the Income Tax Act, 1961. Investments of up to ₹1,50,000 are eligible for annual tax deductions. Although you can invest more, any excess amount will not qualify for deductions.
How can I reduce my investment taxes? ›
Here are 6 of my favorite strategies for lowering investment taxes.
- Consider tax-efficient investments. ...
- Reduce your taxable income with a health savings account (HSA) ...
- Divide assets among accounts with asset location. ...
- Look for opportunities to offset gains. ...
- Take a tax-efficient approach to withdrawals.
Managed funds that actively buy and sell securities, and thus have larger portfolio turnover in a given year, will also have a greater opportunity of generating taxable events in terms of capital gains or losses. This is why mutual funds create a lot of capital gains distributions, especially in comparison to ETFs.
What is the problem with taxation of mutual funds? ›
When looking at the 10 largest mutual funds by asset size, the turnover ratio is almost 75% (1). This means investors will pay higher taxes in the form of distributions due to mutual fund managers selling or buying 75% of the stocks that make up their fund annually.
How is tax calculated on mutual fund income? ›
The income in the form of dividends from mutual funds (now called IDCW) will be taxed as 'Income from Other Sources' as per your income tax slab rate. If the dividend amount is above Rs 5,000 dividend will be subject to TDS as per Section 194K @10% for resident individuals, but if the PAN is not provided then @20%.
How to avoid mutual fund capital gains distributions? ›
The best way to avoid the capital gains distributions associated with mutual funds is to invest in exchange-traded-funds (ETFs) instead. ETFs are structured in a way that allows for more efficient tax management.
How do I avoid capital gains on my taxes? ›
Use tax-advantaged accounts
Retirement accounts such as 401(k) plans, and individual retirement accounts offer tax-deferred investment. You don't pay income or capital gains taxes at all on the assets in the account. You'll just pay income taxes when you withdraw money from the account.
Are mutual funds safe? All investments carry some risk, but mutual funds are typically considered a safer investment than purchasing individual stocks. Since they hold many company stocks within one investment, they offer more diversification than owning one or two individual stocks.
Is it better to invest in a tax free or a taxable mutual fund? ›
Taxable funds generally have higher returns—nominally. But if the tax on those returns effectively wipes out the additional return, the more optimal choice is the tax-free fund.
How are debt mutual funds taxed? ›
Taxability of Debt Mutual Funds After 1st April 2023
As per the latest amendment in the taxability of debt, specified mutual funds can no longer avail of the benefit of indexation while calculating Long-term capital gains. So, debt mutual funds will be taxed at applicable slab rates.
How can I reduce my taxable income? ›
There are a few methods recommended by experts that you can use to reduce your taxable income. These include contributing to an employee contribution plan such as a 401(k), contributing to a health savings account (HSA) or a flexible spending account (FSA), and contributing to a traditional IRA.
How to pay no income tax? ›
Be Super-Rich. Finally, it's quite easy to pay no income taxes if you're extremely rich. In our tax system, money is only subject to income tax when it is earned or when an asset is sold at a profit. You don't have to pay income taxes on the appreciation of assets like real estate or stocks until you sell them.
What are tax-exempt mutual funds? ›
Tax-Exempt Funds
Because tax-exempt mutual funds are comprised of government-issued bonds, which are virtually risk-free, they tend to have much lower rates of return than funds that include more volatile securities. For some, the tax benefits of these assets outweigh their reduction in earning potential.
Can you take money out of a mutual fund without paying taxes? ›
Distributions and your taxes
If you hold shares in a taxable account, you are required to pay taxes on mutual fund distributions, whether the distributions are paid out in cash or reinvested in additional shares. The funds report distributions to shareholders on IRS Form 1099-DIV after the end of each calendar year.
How much tax will I pay if I cash out my mutual funds? ›
Short-term capital gains (assets held 12 months or less) are taxed at your ordinary income tax rate, whereas long-term capital gains (assets held for more than 12 months) are currently subject to federal capital gains tax at a rate of up to 20%.
How to avoid capital gains distributions in mutual funds? ›
The best way to avoid the capital gains distributions associated with mutual funds is to invest in exchange-traded-funds (ETFs) instead. ETFs are structured in a way that allows for more efficient tax management.
How do you avoid TDS on mutual funds? ›
How do I avoid TDS? You can use forms 15G and 15H. If you expect your income tax liability, after factoring in all your income for the financial year, to be nil, you can submit the applicable forms. Form 15G can be used by a resident individual below 60 years of age.
