Though investing can be an excellent way to generate income, your earnings are probably subject to income tax like any other type of income. Mutual funds are a popular investment option for many reasons, but they can actually create a significant tax burden in some cases. Because individual investors do not have any control over the investment activity of a mutual fund, it is important to ensure your mutual fund is tax-efficient. There are a number of factors that dictate your fund's tax efficiency, including the frequency of trading activity, the longevity of each investment in the portfolio and the types of distributions your fund makes.

Mutual Fund Income: The Basics

To avoid paying corporate income taxes on their profits, mutual funds are required to distribute all their net gains to shareholders at least once a year. The income you receive from your mutual fund investment falls into one of two categories: capital gains distributions and dividend distributions.

Dividend distributions occur when your fund includes investments in dividend-bearing stocks and interest-bearing bonds. Capital gains distributions are generated when the fund manager sells fund assets for more than was paid. For example, if the fund invested $100,000 in a stock and then sold all its shares for $110,000, the 10% profit is considered a capital gain.

Mutual Fund Taxation

Depending on how long your fund has held its assets, the income you receive from a mutual fund may be taxed as ordinary income or capital gains. This can be a source of confusion because not all capital gains distributions are taxed at the capital gains rate.

Unlike investing in individual stocks, the application of the capital gains tax rate has nothing to do with how long you have owned shares in a mutual fund but rather how long the fund has held the assets in its portfolio. Only gains from assets the fund holds for a year or more are taxed at your capital gains rate rather than your ordinary income tax rate. Dividend distributions are typically taxed as ordinary income unless they are considered qualified dividends.

Tax Rates

The difference between your ordinary income tax rate and your corresponding capital gains tax rate can be substantial. Individuals in the 10 and 15% income tax rate brackets are not required to pay any tax on their capital gains. Those in the 25%, 28%, 33% and 35% brackets are subject to a 15% capital gains tax, while those in the 39.6% bracket must pay a 20% tax on capital gains.

For example, assume you are in the 28% income tax bracket and receive $1,000 in investment income from the sale of stock. If you have held the investment for a year or more, you are only required to pay 15%, or $150, in taxes. If it is short-term gain, however, you must pay $280.

Efficiency Factor: Asset Turnover

One of the most effective ways for a mutual fund to increase its tax efficiency is to reduce its turnover ratio. A fund's turnover ratio refers to the frequency with which the fund buys and sells securities. A fund that executes many trades throughout the year has high asset turnover. The result is most capital gains the fund generates are short-term gains, meaning they are taxed at your ordinary income tax rate.

Funds that employ a buy-and-hold strategy and invest in growth stocks and long-term bonds are generally more tax-efficient because they generate income that is taxable at the lower capital gains rate. When a fund distributes capital gains, it issues you a Form 1099-DIV outlining the amount of the distribution attributable to long-term gains.

In addition, very active mutual funds tend to have higher expense ratios, or the amount of money the fund charges each year to maintain itself and cover administrative and operating costs. Though this does not have a huge impact on your yearly taxes, it can be a substantial drain on your finances.

Efficiency Factor: Dividends

If your mutual fund contains investments in dividend-paying stocks or bonds that pay periodic interest, called coupon payments, then you likely receive one or more dividend distributions a year. While this may be a convenient source of regular income, the benefit may be outweighed by the increase in your tax bill.

Most dividends are considered ordinary income and are subject to your normal tax rate. Funds that do not pay dividends, therefore, are naturally more tax-efficient. For those whose investment goals are geared toward growing wealth rather than generating regular income, investing in funds that do not include dividend-bearing stocks or coupon-bearing bonds is a smart move.

A Middle Ground: Qualified Dividends

Some investors find dividend distributions to be one of the chief benefits of fund ownership but still want to reduce their total tax burden as much as is possible. Luckily, some dividends may be considered "qualified dividends" and be subject to the lower capital gains tax rate.

For dividends to be considered qualified, they must meet certain criteria, including a holding period requirement. Qualified dividends must be paid by a U.S. or eligible foreign corporation and purchased before the ex-dividend date. The ex-dividend date is the date after which subsequent share purchases are ineligible for the upcoming dividend. The stock must have been held for at least 60 days within the 121-day period that begins 60 days before this date.

Like capital gains, whether your dividends are considered qualified has nothing to do with how long you have owned shares of a mutual fund but rather with how long the fund has owned shares of the dividend-paying stock and when those shares were purchased. Even if you purchase shares in a mutual fund tomorrow and receive a dividend distribution next week, that dividend is considered qualified in the fund as it meets the above holding requirement.

Once again, funds that employ a buy-and-hold strategy are more likely to generate qualified dividends, as well as long-term gains, making them more tax-efficient overall. Funds that distribute qualified dividends report them on Form 1099-DIV, just like long-term capital gains.

Efficiency Factor: Tax-Free Funds

Another way to ensure you invest in the most tax-efficient funds is to choose funds that include investments in government or municipal bonds, which generate interest not subject to federal income tax. Some funds invest only in these types of securities and are often referred to as tax-free funds.

Even if your mutual fund is not a tax-free fund, funds that include some of these types of securities are more tax-efficient than those that invest in corporate bonds, which generate taxable interest subject to your ordinary income tax rate.

However, some municipal bonds are actually more tax-free than others. While all are exempt from federal income tax, some are still subject to state and local taxes. Bonds issued by governments located in your state of residence, however, may be triple-tax-free, meaning they are exempt from all taxation.

If you are looking to invest in mutual funds or are simply reassessing your current holdings, examine each fund's portfolio to ensure your investments do not end up costing you at tax time. Choose funds with low turnover ratios that include nondividend-bearing stocks, zero-coupon bonds and municipal bonds.

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