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Mutual fund taxation

By David Luhman on Sat, 05/09/2009 - 23:54

Mutual fund taxation


Before investing in a fund, you should consider the tax consequences. Here, one of the most important questions you should ask is, "Is this fund going to be taxable or will it be sheltered in a retirement account?" The answer will affect which fund you should select.

Always ask "Is this for a retirement account?"

Whenever someone asks me, "Which fund should I invest in?" I always reply, "What's the objective of the investment?"

If they respond, "Retirement", my second question always is, "Are you investing this money through a retirement account like an IRA or a 401(k)?"

If you're saving through a retirement account, picking mutual funds becomes much simpler because you don't have to worry about taxes until you retire and begin to withdraw the funds.

Let's say that you've invested in mutual funds through an IRA or 401(k) type account. You can trade those funds as many times as you want inside the retirement account and you won't have to pay any capital gains taxes or taxes on the distributions made by the fund until you retire.

Keep trading and income funds inside retirement accounts

So if you like to trade, you should do your trading inside your retirement accounts. Likewise, you should keep funds that have high distributions inside your retirement accounts.

Here's an example to show how you might want to manage mutual funds in taxable and non-taxable accounts. Assume you're 35 years old, single, and don't have a retirement plan at work. Since you're on your own, you figure you need to save at least $4,000 per year for retirement.

About the only retirement account option for you is an IRA, but your contributions to an IRA are limited to $2,000 or your earned income.

You could save for retirement through an annuity, but annuities are expensive and inflexible, so this isn't a great option.

So to minimize your taxes and have a balanced portfolio, here's what you could do. Put $2,000 into your IRA, and the other $2,000 into a normal, non-sheltered mutual fund.

You're still pretty young, so you can afford to put most of your retirement money into stocks. Of the $2,000 that you put into your IRA, you might want to put $1,000 into bonds, and $1,000 into blue chip stocks.

Of the remaining $2,000 which can't be put into the IRA, you might want to put this into a an index fund which invests in small company stocks. If you do this your total portfolio provides you with good diversification across bonds and various types of stocks, and ensures that you'll pay a minimum in taxes.

Bond funds tend to make high distributions of their interest earnings. By placing the bond portion of your portfolio inside the IRA, you won't have to pay taxes on the interest earnings until you retire.

Blue chip stock funds also tend to make high distributions of dividends paid by established companies. By placing these high-dividend-paying stocks inside your IRA, you again avoid paying taxes until you retire.

Use small cap index funds outside of retirement accounts

Finally, your unsheltered investment in the small company stock index fund saves you in taxes as well. Index funds simply buy and hold a predetermined basket of stocks like the Standard & Poors 500 index for large companies, or the Russell 2000 for small companies.

Index funds don't have many internal trades, so they don't have many internally realized capital gains distributions. This reduces your annual tax payments.

Also, small company stocks usually make low dividend payments. They're growing companies, so they don't want to pay out their profits as dividends. They reinvest their profits in the business so the business can grow further.

The low dividend payments made by these companies means that they'll probably grow faster than the more established blue chip companies. This hopefully will translate into a higher share price for you. But you won't have to pay any capital gains taxes on the higher share prices until you sell the shares.

Money market funds simplify your taxes

So when you invest in mutual funds outside of a retirement account, try to minimize your taxes by selecting a fund with low trading activity and low distributions.

However, even the most tax-efficient stock or bond fund will complicate your taxes if it's not inside a retirement account.

Money market mutual funds, however, don't complicate your taxes because these funds try to maintain a stable share price. All the money you make with money market funds is essentially interest income, and you shouldn't have any capital gains or losses.

But if you invest in a bond or stock fund, your taxes become more complex because of capital gains. In fact, because of tax complications, you may want to think twice about investing in bond funds outside of a retirement account.

Bond funds versus CDs - tax complications

Bond funds generally pay higher interest rates than bank certificates of deposit, but bank CDs offer two advantages. One is stability of principal. Bond fund prices can go up or down depending on interest rates and other factors.

The other advantage of CDs is simplicity of taxes. If you invest in a bond fund outside of a retirement account, you'll have a capital gain or loss to report on your taxes when you sell the shares.

Figuring the tax on all this isn't too difficult, but it is more complex than if you had just stuck with the bank CD. Listen to my tape on income taxes if you need more information on mutual fund taxation.

The bottom line is that if you're dealing with a small amount of money and a short time frame, you might want to skip mutual funds and stay with the good old bank or a money market mutual fund. You may not make as much in interest, but your taxes will be simpler.

But you should consider putting some of your retirement account money into mutual funds because of the much higher returns they may offer.

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