Today, I would like to talk about open-end mutual funds- specifically when a person does not own them inside a retirement plan account or another tax shelter. Most investors know the basics of how open-end mutual funds work, but in my experience, the tax implications are often an area of pain and confusion. As a bonus, if you read this whole article, I’ll present a few ideas to help reduce or eliminate that tax bite, if you had one this year.
Open-end mutual funds have managers, and they will buy and sell the investments in the portfolio in an effort to meet the fund objectives. Each purchase and sale carries with it tax consequences that are ultimately passed down to the shareholders. Some sales are from securities held more than a year, and they get long-term capital gains tax treatment. Some are held less than a year, and they get short term capital-gains treatment, which is generally a higher tax rate than long-term gains. Dividends and some kinds of interest are also taxable. When a security is sold at a price less than what was paid for it, a tax loss is generated. Losses will help offset long-term gains and reduce the tax liability. Fund companies track all of this and send out a 1099-DIV each year.
Interestingly, and often quite disappointingly, a person can have to pay taxes on their mutual fund even though it lost money. It works like this. Let’s say each share is worth $9.50 on January 1st. The managers traded stocks during the year, and the end result on December 31st is a price of $7.00 per share. So the fund is down from where it was bought, and now insult is added to that injury. All those buys and sells that the manager made during the year are calculated, and it is determined that there is a taxable capital gain of $2 per share. Often that gain can be taken as a check or re-invested in the fund- but it is still taxable. So in this instance, even after a capital gains payout and having to pay taxes on it, the net result is a loss for the year.
Selling a mutual fund can also generate those taxes for you if it is a gain over what you paid. It is important to keep track of those tax statements each year- especially if you had the gains reinvested. Otherwise, you may needlessly pay taxes on those gains again when you sell it, since those reinvested gains bring your cost basis up. Further, even a free exchange into another fund within a fund family counts as a sale, so just moving your investments around can generate taxes and erode your real return.
Now let’s talk about three ways to mitigate those taxes.
#1 Use a tax-managed mutual fund. These funds are asserting that they’ll be managed in a manner to reduce the tax consequences, when possible. Even when they do there are no guarantees that you’ll be happy with the results, as they cannot be controlled by you.
#2 Use more tax-efficient investments where possible, like ETFs or individual stocks. Equity ETFs that have a low internal turnover- the term used for all the buying and selling inside the fund, will have little to zero tax consequences when you hold them. Just like stocks, you’ll have your own cost basis, so if you need to sell some you’ll know exactly what the coming tax bill will be. Further, you may be able to sell some positions at a loss to offset those gains and reduce those taxes. This strategy is called tax-loss harvesting.
#3 Use a tax shelter. Qualified retirement plans are tax shelters and the best place to invest for retirement. However, Roth IRAs have some unique features compared to other retirement accounts, and one of them is the ability to access your contributions first- without income taxes or the 10% early withdrawal penalty that accompanies most other qualified retirement plans. Although any gains you have may be tied up for retirement, it is nice that in an emergency you could access what you put in. Other tax shelters also exist, like annuities. There are different kinds of annuities, including fixed, fixed-indexed, and variable annuities. What primarily makes them different is what they are investing in- but all are tax-sheltered. When accessing them the gain comes out first, and it is taxed at ordinary income tax rates. Additionally, if you’re under age 59 ½ there is a 10% early withdrawal penalty.
These tips are meant as a starting point if they seem helpful to your situation. There are rules regarding each one that we can’t fully elaborate on in this space. Please thoroughly research or gain the advice of a qualified professional before implementing any of them.
Michael Thomas owns and operates Thomas Capital Management, LLC in Hamilton, MT. He has 22 years of industry experience. When not at the office he greatly enjoys spending time with his family, making progress on endless projects on his homestead, and tending to his chickens and ducks.
Thomas Capital Management, LLC, 274 Old Corvallis Road, Suite K, Hamilton, MT 59840. Registered Representative, Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Cambridge and Thomas Capital Management, LLC are not affiliated.