If you own mutual funds that are not in a tax-free account, filling out 1040 can seem daunting. Sometimes there is an intimidating array of rules and calculations on the forms. As it happens, though, there’s a number of ways to make your mutual funds investing tax-efficient.

Key Takeaways

  • Stock funds are taxed at the capital gains tax rate.
  • Bond funds are taxed differently, and some are even tax-exempt, such as those that invest in municipal bonds.
  • International funds are often taxed (once) at the issuing country's tax rate. However, you may have to pay taxes twice if the issuing country has no tax treaty with the U.S.
  • Putting investments into investment accounts like 401(k)s or IRAs ensures you are maximizing your tax-savings potential.

Stock Funds

There is a difference between the tax liability for a stock and a bond fund. Stock funds, if they trade the component stocks, get taxed on the capital gains. They also issue distributions, which are also taxable.

For capital gains, there are two rates: short-term (less than one year) and long-term (for assets held longer than one year). Long-term capital gains are smaller with a maximum of 20%. Most people pay the 15% rate or 0%. Short-term gains are taxed as ordinary income.

Stock funds sometimes make distributions, and that could be dividends or simply gains from sales of stock; in the former case, they can be taxed at the long-term capital gains rate. Fund distributions are taxed whether or not the money is put back into more shares of the fund. And, of course, there are taxes if the fund shares are sold at a gain (or deductions if there is a loss).

Bond Funds

Bond funds are a bit different. The interest earned is taxed as ordinary income. But there are some added wrinkles depending on the kind of bond fund you buy. For example, there are tax-free municipal bond funds, but generally, the tax break only applies if you live in the same state those bonds were issued in.

In most cases, municipal bond funds are not taxable at the federal level, while federal debt (e.g., Treasury Bill fund) will be exempt from state income tax but still taxable at the federal level.

International Funds

This gets us to the third category of funds—international. Sometimes international funds aren't taxed, because of the foreign tax credit. In order to avoid taxing people twice the Internal Revenue Service (IRS) allows credits for foreign taxes paid already. That can make them a good diversifier and a tax hedge. However, it's important to look carefully at what countries the funds cover. Countries with a tax treaty with the U.S., you may get taxed twice.

Tax Efficiency

Even though the tax rules are complicated for funds, tax efficiency can still be maximized. First, minimize trading. A fund that trades a lot will incur more taxes, period. A useful strategy is to put bond funds in a 401(k) or individual retirement account (IRA), for example, while keeping the stock funds in a taxable account. The reason is that bond fund distributions are taxed at whatever rate applies to your income, which means that every year there will be a tax hit.

There's also no guarantee that stock funds will outperform bond funds (or vice versa) or that interest rates will remain as low as they are, so the simplest thing is to defer the taxes until you withdraw the money.

Stock funds, meanwhile, get taxed at the capital gains rate, which much of the time is lower than the rate on ordinary income. That means it's actually better to pay the smaller rate every year rather than the larger rate on the income from selling off the fund shares down the road. 

One type of index fund is an exchange traded fund (ETF). ETFs can prove to be more tax-efficient because an ETF that is rebalancing will not have to pay the same taxes as a mutual fund. In practice, fund managers will almost always sell the highest cost basis stocks first, which means they'll unload the stuff that's losing money or making less money, and pay less in capital gain.