Strategies for Legally Avoiding Capital Gains Tax on Mutual Funds

Strategies for Legally Avoiding Capital Gains Tax on Mutual Funds

how to avoid capital gains tax on mutual funds

In the long run, if you sell an investment asset to make a profit, you will have to pay capital gains taxes. But for active investors, it’s important to understand that the IRS offers several ways for you to defer these taxes. This type of tax planning can be particularly useful with more complex products like a mutual fund. If you want to avoid having to pay taxes the next time you move money, here are some ways to manage your assets.

For proper tax planning to anticipate any potential liability, you can also work with a financial advisor specializing in taxation.

Capital gains taxes and mutual funds

Mutual funds are popular investment vehicle because of the balance they can potentially bring to your portfolio. Not everyone thinks about the potential tax consequences of investing in a mutual fund before taking the plunge, but it’s important to understand them before investing. There are two main ways to pay taxes on a mutual fund.

  • Ordinary income tax: If you have a income generating fund, you may pay ordinary income taxes on the money distributed by the fund. Returns such as interest and nonqualified dividends are taxed as ordinary income in the year you receive them, and many mutual funds generate these payments.

  • Capital gains: The most common method is to go through capital gains taxes. You owe capital gains taxes on profits you earn whenever you sell an investment asset or receive qualified dividend payments. So, for example, let’s say you bought a mutual fund at $100 per share and sold it for $150. You should capital gains taxes on the $50 profit you received on this sale.

You may also have to pay capital gains taxes depending on the activity of the fund. A mutual fund is a portfolio of underlying assets. Each share represents a percentage of ownership of these assets as a whole. When a mutual fund sells assets in its portfolio To obtain a gain, he can, in most circumstances, do one of two things. Sometimes the fund will reinvest the proceeds in new assets. However, in other cases, the fund will return the proceeds of any sales to its investors on a per share basis in what is called a “capital gains distribution.”

In most, if not all cases, when a mutual fund is managed competently, you will not see any tax consequences from a reinvestment. However, if you receive a capital gains distribution, you may have to pay capital gains taxes on that money. This is how mutual funds can cause tax events for their investors even if you don’t sell a single share.

How to Handle Mutual Fund Capital Gains Taxes

how to avoid capital gains tax on mutual fundshow to avoid capital gains tax on mutual funds

how to avoid capital gains tax on mutual funds

So how can you handle capital gains taxes on your mutual fund? You can do this in several ways, including:

1. Hold funds in a retirement account

The easiest way to deal with any form of capital gains tax is to keep your investments in a qualified retirement account. Generally, the IRS does not consider the sale or handling of these assets a tax event until you make a withdrawal from the account.

This means you can sell shares of your mutual fund or take a capital gains distribution without paying related taxes as long as you keep the money in that retirement account. Of course, you will ultimately owe all associated taxes once you withdraw the money.

2. Distribution of capital gains

Apart from a qualified, tax-advantaged retirement account, there is little you can do to avoid taxes on a capital gains distribution once it has been made. Generally speaking, the best way to handle taxes on capital gains distributions is to avoid paying them.

Look for funds that have a low turnover rate. This means they tend to sell and move assets less frequently than other funds. The longer a mutual fund holds its assets, the fewer sales and distributions it will generate. Also look for funds that tend to reinvest profits rather than issuing distributions. Again, this will often, but not necessarily always, allow you to avoid tax events. Index Funds They often manage assets this way, so it’s a good place to start.

3. Long-term capital gains

While this is true for all investment assets, not just mutual funds, try not to sell assets you’ve held for less than a year. If you sell something within a year of purchasing it, it is considered a short-term investment and is taxed at ordinary income rate. If you sell something after holding it for a full year, it is taxed at a significantly lower capital gains rate.

4. Manage shares

When you sell shares of a mutual fund or any other investment asset, your profit is calculated based on what you paid for the underlying asset. Like our example above, if you buy shares of a mutual fund for $100 and sell them for $150, you will be taxed on the $50 difference.

But let’s say you’ve invested in this mutual fund over time, paying different amounts for your shares with each investment. In this case, you can choose to specify which shares you decided to sell, and your taxable profit will be based on this difference.

For example, let’s say you purchased three shares in a mutual fund, paying $100, $120, and $140 for each share (respectively). You now sell a stock for $150. No matter which shares you sell, you will get back the $150. But if you specify that you sold the most recent stock, you will only have to pay taxes on $10 of capital gains ($150 sale price – $140 purchase price).

However, this type of management has a trap. Ideally, your fund will continue to grow, meaning you’ll owe even more taxes once you finally sell the $100 and $120 shares. However, while it is useful to manage your cash flow this way, it is a valid tax planning tool.

5. Harvesting tax losses

Finally, many investors use a tool calledharvesting tax losses» which can be tricky. Capital gains tax is based on net profits during the year. This means that you add up all your profits from the sale of profitable investment assets, subtract all your losses from the sale of unprofitable investment assets, and then pay taxes on the final amount.

This means you can sell certain assets at a loss to reduce your total capital gains in a given year. For example, let’s say you make $50 by selling one share of your mutual fund. Let’s say you also own a stock that is currently worth $20 less than what you bought it for. You can sell these shares before the end of the year, realizing a loss of $20. This would partially offset your mutual fund’s gain, bringing your total taxable gain to $30.

The problem with harvesting tax losses, of course, is that it means suffering a loss. This strategy is generally a good idea if you have investments that you were going to sell anyway. It’s not worth liquidating a good investment too early just to get a tax break. However, it may be worth planning your exit from a bad investment if it can help you offset taxes elsewhere.

The essential

how to avoid capital gains tax on mutual fundshow to avoid capital gains tax on mutual funds

how to avoid capital gains tax on mutual funds

There are two main ways to be taxed on a mutual fund: sell your shares or collecting a capital gains distribution. Although you can’t fully defer tax on these gains, you can handle them in a few different ways, described above. The important thing is to understand how you might be taxed so you can properly plan the tax you might have to pay, depending on what you want to do with your investments.

Tax Planning Tips

  • For many investors, mutual funds are a great way to balance diversification and gains. But are you one of them? The free SmartAsset tool connects you with up to three financial advisors who serve your area, and you can survey your advisors for free to decide which one is best for you. If you are ready to find an advisor who can help you achieve your financial goals, start now.

  • We’ve delved even deeper into how it can all work for you in our in-depth review of how taxes work with mutual funds.

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