How to Avoid Over-Taxation on Mutual Funds

Buying mutual funds is a smart way to invest in the stock market for those who want instant diversification and professional management, but buying into the wrong fund or buying at the wrong time can result in over-taxation. Avoid over-taxation of mutual funds by following these guidelines.

Instructions

Difficulty: Moderate

1. Ask the fund managers if they are getting ready to make a taxable distribution before you buy into a fund, especially if you are investing late in the year. You will pay tax on this distribution, even though you don't get the benefit of the gain. Also ask if the fund has loss carry forwards (losses from prior years) that can be used to offset gains in the current year.
2. Search for funds with low turnover rates. This means stocks are not bought and sold frequently throughout the year. You pay capital gains taxes on these transactions if the stocks are sold when the prices go up. Look for a fund with a turnover rate of 10% or less to find a tax-efficient fund.
3. Place tax-inefficient funds (those with a high turnover rate) in tax deferred accounts, such as a 401(k) plan or an IRA. Tax-inefficient mutual funds may be profitable, but the tax bite reduces their profitability unless you shelter the gains by deferring the taxes.
4. Look for funds where the managers invest their own money in the funds. These managers are likely to be thinking about taxes as much as you are since they are in the same boat as the rest of their investors. Fund companies are not required to disclose whether the managers are also investors, but, if you ask the manager(s) directly they will usually tell you if they have a stake in the fund.
5. Consider investing in mutual bond funds, especially if you are looking for regular, predictable distributions (fixed-income). These funds invest in local government bonds which are usually tax-exempt. These funds may pay a lower rate of return, but it's offset somewhat by the fact that it's tax-free income.
6. Look into tax-managed funds. These funds use a series of strategies to limit taxable distributions. Companies like Vanguard, Fidelity and Putnam offer tax-managed funds.

Tips & Warnings

• You can find the turnover ratio of funds on Morningstar's Quicktake Reports. See the Resource section for this information.
• Don't let concern over taxes keep you from investing in a highly profitable mutual fund. Good performance is still the most important consideration in picking a mutual fund.