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.
First, it's important to note there is a difference between stock and bond funds' tax liabilities. Stock funds, if they trade the component stocks, get taxed on the capital gains. They also issue distributions, which are also taxable. (For more, see: Capital Gains Tax 101.)
For capital gains, there are two rates: short-term, or less than one year, and long-term, for assets held longer than one year. The latter is smaller, a maximum of 20%. Most people pay the 15% rate or zero, though few who own mutual funds are in the lowest bracket. 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). (For more, see: What Is the Difference between Capital Gains and Investment Income?)
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 (a treasury bill fund, for example) will be exempt from state income tax but still taxable at the federal level.
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. (For more, see: Understanding Taxation of Foreign Investments)
However, it pays to look carefully at what countries the funds cover. "If that country doesn't have a tax treaty [with the United States] you can get taxed twice," said Allan Roth, founder of investment advisory and financial planning firm Wealth Logic.
Even though the tax rules can get complicated for funds, there are still ways to maximize tax efficiency, Roth said. First, minimize trading. A fund that trades a lot will incur more taxes, period. Another is to think about the "wrapper" the funds are in — your tax-deferred 401(k) plan, or a taxable account at your local broker or financial advisor. (For more, see: Retirement Savings: Tax-Deferred or Tax-Exempt?)
Roth suggests putting 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. That adds up over time. 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, Roth said.
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.
To further minimize taxes, Roth added that an index fund is the best bet. There's little trading in index funds which means the number of taxable "events" is smaller. Dividends will get taxed at a lower rate than regular income, so the taxes take less bite out of returns.
As for international funds, similar reasoning applies: go with index funds and stay with the ones that have countries with tax treaties insofar as that's possible.
One type of index fund is an exchange-traded fund (ETF). The theory, Roth said, is that they are more tax-efficient because an ETF that is rebalancing or the like won't 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. (For more, see: What Determines Your Cost Basis?)
The largest ETF, the SPDR S&P 500 ETF (SPY) has a gross expense ratio of 0.1098% and follows the S&P 500. The Vanguard S&P 500 fund (VFINX) charges 0.17%. That difference is rather small, so in some cases, the choice might matter little.
The Bottom Line
Tax-efficient investing might involve a little juggling of what kind of account you put funds in, but once done it's well worth it. (For more, see: When to Sell a Mutual Fund.)