A mutual fund is a company that pools money from individual investors to build an investment portfolio of stocks, bonds, money market funds, etc. Many people at one point of their lives have invested in mutual funds. As the owner of a mutual fund you are taxed when you sell your mutual fund share and when the mutual fund sends your share of profits or interest from the funds. Your share of profits are taxed even if you do not actually take the money out.

How not to pay too much taxes on your mutual funds

Yearend purchases

Do not buy mutual funds at the end of the year. Mutual funds need to distribute 98% of their profits by the end of the year. So therefore, in December they make large capital gains distributions. If you catch the year end wave, you have to pay taxes on this distributions even though they do not benefit you. This is because the share prices drop by the amount of the distribution. You can find out on the website of the mutual funds to see when capital gains are scheduled so you can avoid this undesirable tax consequence.

Selling your mutual fund shares

Mutual funds shares are usually bought at separate times. Each time you buy a mutual fund, you pay a different price. The gains on your share depends depends on how much you paid for the share. When you share the mutual fund shares with the highest basis first, you have lower gains thereby minimizing the taxes you have to pay on the gains. Of course, there are other considerations like your tax bracket that will come into play.

When selling your share be sure to advice your broker to use the specific identification method. A lot of documentation is required by the IRS if this method is used, but it is worth it if you have large investments in mutual funds. Moreover, when you choose a method, you have to stick to it for as long as you own the mutual fund.

Tax efficient mutual funds

In mutual funds, you have very little control of how the money is distributed to you. However, there are funds that are more tax efficient when compared to other funds. For the most funds, index funds are more tax efficient because they are not actively managed. The securities in these funds are not traded very often which lessens the taxes you have to pay on gains. Also, mutual funds have to show their after tax investment returns in their prospectus and you can use this information to help you make your decision.

Finally, look into ETF funds as they are often more tax efficient and have less operating expenses than mutual funds.