When your mutual fund units are worth more than you paid, that's usually a good thing. It means they're doing what they should, which is increasing your net worth. However, that success might occasionally be inconvenient. If your funds have realized capital gains through the year, you'll be on the hook at tax time. You can minimize your capital gains tax liability by following a few simple strategies.
Maximize your tax-sheltered investments first. Hold your mutual funds in an IRA or a 401(k) as long as you can, where they can grow without taxation.
Avoid funds with an active trading strategy. Funds that buy and hold investments for the long term sell less often, generating fewer taxable gains. Index funds also typically have low turnover.
Purchase funds with a "tax-efficient" or "tax-managed" investment strategy. Funds with this philosophy offset significant capital gains by selling some of their losing investments, providing a corresponding loss to soften the tax impact.
Take a capital loss elsewhere, if your fund manager hasn't done it for you. It's a useful opportunity to unload your Uncle Phil's "can't miss" stock pick from 2008, and use that loss to reduce or eliminate your tax burden.
Defer your mutual fund purchases late in the year. At the end of the year mutual funds calculate their gains and share them equally among unit holders, so if you've just bought the fund you'll share the tax burden without sharing the actual gains in value.
- If you're sheltering mutual funds inside an IRA or 401(k), bear in mind that capital gains are taxed at a lower rate than dividend or interest income. Once you reach your contribution limit, the smart strategy is to keep higher-tax investments where they're sheltered and hold funds that generate capital gains outside of your IRA.
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