Taxes: Mutual Fund Taxation - Ch 10 Boglehead Series at Catch a Gideon

November 14th, 2006 by digerati

This is Chapter 10 in the Bogleheads series at Catch a Gideon. We are going through each chapter in the book and letting you know what we learned from reading it. You should buy the Bogleheads Guide to Investing. It has more examples and more depth than I’m giving here, and is overall an excellent investment book.

This chapter discusses how mutual funds are taxed. The impact of taxes on return can be large. For instance, I will likely be in the 28% tax bracket this year. That means that any income I earn from investments in taxable accounts gets about a third taken out of it for taxes. If I had a 9% return it would effectively be 6%.

How are Mutual Funds Taxed?

Dividends and capital gains are the two sources of taxation on mutual funds.

Stock Dividends

Dividends account for about a third of total return on investment in the United States annually. The Reconciliation Act of 2003 reduced the dividend income tax rates to a maximum of 15% until the end of 2007. (Those in the 5 and 10% income brackets saw their tax on dividends decrease to 5%). Prior to the Act dividends were taxed at the highest marginal tax rate of the investor.

Bond Dividends

These are actually the bond yield, but sometimes described as dividends. Bond dividends are not qualified for the lower tax rate, so are taxed at the investors marginal income tax rate (up to 35%). Therefore it is advisable to place taxable bonds in a tax sheltered account.

Capital Gains

A capital gain occurs when something is sold for a profit. The capital gain is the difference between the purchase and sell price. If the stock or bond in question sells for less than the purchase price, it is a capital loss. A mutual fund will incur a realized capital gain or loss every time a stock is bought or sold. Periodically (certainly annually) the fund manager will add up all the gains and losses. In the result of a net gain, it is passed onto the shareholders of the fund. If the result is a net loss, the amount is carried over to the following year to offset gains.

Unrealized capital gains and losses are the value of securities that have yet to be sold. The net unrealized gain or loss can be found in the fund’s prospectus. Unrealized gains can of course become realized gains, and a potential investor should note the unrealized gains before investing. A fund can be more tax efficient by selling off unrealized losses before the end of the year.

Short and Long Term Capital Gain

Short term is when a mutual fund or security is held less than 12 months. Long term is over 12 months. Tax rates differ for the two of them, short term being higher (usually taxed as normal income) and long term lower (maximum of 15%). It is advisable to plan to hold mutual funds for more than one year. Otherwise the tax burden significantly reduces the benefits and return.

Obviously, there is no tax if a security is not sold by the mutual fund. An investor should therefore look for a fund with low turnover. With less turnover the fund incurs fewer realized capital gains (which are taxed) and also the fund incurs a lower long term capital gain tax rather than a short term higher tax.

Investing

Mutual funds are required to report before and after tax returns in the prospectus. From this you can determine the tax efficiency of the fund. Efficiency is generally high in bear markets and lower in bull markets. Keep in mind that selling a fund will require you to pay capital gains tax on that amount. If you plan to move the money to a different fund, keep in mind that you will be placing a smaller amount in this new fund. A better return may not justify a smaller amount invested, depending of course on the circumstances. Generally you want to use index funds or tax managed funds in a taxable account. Save the other funds for your non-taxed accounts (IRA, 401k).

Some tips offered to help reduce the taxes paid on your portfolio:

Keep turnover low. Buying and selling means taxes. If you hold securities for a longer time you will pay fewer taxes
Use only tax efficient funds in taxable accounts.
Avoid short term gains. They are taxed at about twice the rate as long term gains.
Buy fund shares after the distribution date. If you buy after the distribution you won’t pay taxes on that distribution, but the value of the fund will be the same.
Sell fund shares before the distribution date.
Sell profitable shares after the new year. Waiting until January means you get taxed the following year.
Harvest tax losses. This means “selling losing securities in taxable accounts for the purpose of obtaining tax losses to reduce current and future income taxes.“

If you haven’t done it yet, buy the Bogleheads Guide to Investing. It’s a great book.