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How Mutual Funds Are Handled on Tax Returns

How Mutual Funds Are Handled on Tax Returns

One thing that can help you improve your total portfolio return is through understanding mutual fund taxation in a way of reducing or eliminating taxes on your mutual funds. And to make it even better, it will be a big help for you to maximize returns while minimizing unwanted taxes through learning which types are best and which ones to avoid for taxable accounts.

Here are some of the things you need to know about mutual fund taxation:

Asset Location: Placing mutual funds that generate high relative taxes within their taxable accounts is one of the biggest mistakes that investors make. So, in order to avoid needless income tax from most bond funds and dividend-paying stock funds that generate income that is taxable to the investor, you have to purchase a tax-deferred account such as an IRA, 401 (k) or annuity instead.

Tax-Efficient Funds: If you want to minimize taxes in your taxable account such as a regular individual or joint brokerage account, investing in mutual funds that generate little to no taxes is what you should do. These funds are said to be as tax-efficient funds. For instance, you might consider using municipal bond funds if you need exposure to bonds since this generates income which is generally tax-free at the federal level. Thus, it is a must for you to avoid funds that pay dividends in which will generate more taxes than those that pay little or no dividends.

How Mutual Fund Dividends Are Taxed?

Some companies stockholders get their profits in the form of dividends. Therefore, the mutual fund shareholders receive dividends in the mutual fund they invest in stocks from the companies in which they invested.  A mutual fund investor chooses to reinvest their dividends into the fund even though there may be incurred taxes from it. The holding period and income tax bracket, among other things, will be the basis of the amount of taxes owed.    

  • Types of 1099 Forms and What to Do With Them

1099-R, 1099-DIV, 1099-INT and 1099-Q are the most common types of 1099’s received by the investors but somehow this often surprised them when receiving 1099 in the mail. With this notable sign, a need to understand why they received the 1099 and if the taxes incurred by the mutual fund investing can be minimized or avoided should be done by the investor. Understanding 1099 forms is a great place to start if you want to know the basics of mutual fund taxation. Not only that, you need to surely do also what IRS requires you to do.

  • Mutual Fund Capital Gains Distributions

Dozens or hundreds of stocks may be invested from stock mutual funds. Buying and selling shares of several of the stocks within the mutual fund during any given year is what often done by the mutual fund manager. The gained value since the time the manager sells the stocks that he or she has purchased generates capital gains which are then passed along to you as the investor.

  •  Plan Ahead for Your Capital Gains Distributions

Beginning in October, mutual fund companies generally post capital gain distribution estimates in order to help shareholders prepare for capital gains distributions. Planning ahead for a tax day with the use of capital gain distribution estimates will be a big help for mutual fund investors ( who own funds held in taxable accounts).

  •  Tax Loss Harvesting

Many investors could have reduced or eliminated capital gains taxes by offsetting the gains with capital losses but unfortunately, many investors make mistakes with this. For instance, you decided to sell shares of two funds because you want to rebalance your portfolio, your $1,000 of capital gains as a result of selling the first fund and $1,000 of capital losses as a result of selling shares of the other fund, since the gains and losses are equal, it will offset each other so no tax is owed.

  • Tax Cost Ratio

A measurement of how taxes impact the net returns of investment is considered as tax cost ratio. Given in this example, a tax cost ratio of 1% results from the 10% return earnings of your mutual funds and the 9% overall return of the tax cost incurred by the reduced fund. Pre-tax returns, tax-adjusted returns and tax cost ratio for mutual funds can be found at Morningstar.

  • Index Funds vs Actively Managed Funds

“Beat the market” funds are called actively managed funds while passively managed funds are funds that simply match the returns of the market or given benchmark. Typically, actively managed funds have higher turnover ( buy and sell more stocks or bonds) therefore have higher tax costs than index funds and Exchange Traded Funds (EFTs).In order to have tax efficiency, you have to consider using one of the best S&P 500 Index Funds.

  • How to Choose the Best Mutual Funds

It is not a coincidence that mutual funds are considered to be the best are often funds having the lowest tax costs especially over long periods of time, like 10 years or more. Therefore, in looking for the best performing funds, find the most tax-efficient funds. Remember, there is a high correlation between low tax costs, low turnover ratio and low expense ratios to high relative returns, especially for the investment of longer periods.

It is said that "Nothing is certain in life but death and taxes." So by choosing tax-efficient funds for your taxable accounts, taxes can be minimized or even be avoided. These funds are growth stock funds, index funds, and municipal bond funds. And having the basic knowledge of mutual fund taxation will enable you to increase your overall investment portfolio returns.


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