Tax Managed Mutual Funds: When To Invest For Maximum Benefits

Tax-managed mutual funds are an increasingly popular investment vehicle that can help investors minimise their tax burden. They aim to pay little to no capital gains and are designed to generate returns via fund price increases, while avoiding annual capital gain distributions. These funds are particularly useful for investors who want to hold mutual funds in taxable accounts.

There are two types of capital gains: sale of shares and embedded gains. Fund owners pay short-term or long-term capital gains taxes if they sell shares of a mutual fund. Mutual funds that sell stocks or bonds for a gain pass on these capital gains to fund owners.

Tax-managed mutual funds use a variety of strategies to minimise taxable transactions, such as tax loss harvesting, tax-advantaged securities, and investor control. They also have an obligation to minimise taxable transactions within the fund itself.

Tax-managed funds and their ability to avoid tax pitfalls

Taxes can be one of the biggest expenses on investments. Investors should review the tax obligations associated with different accounts before investing in them. A financial or investment professional can help with this.

Mutual funds are simply a basket of assets overseen by a professional money manager. They pay out dividends, capital gains and other income to their owners each year on a pro-rata basis. The fund owners must then pay ordinary income or capital gains taxes on these distributions each year if the funds aren’t held in tax-advantaged accounts.

There are two types of capital gains to be aware of:

• Sale of Shares: Fund owners pay short-term or long-term capital gains taxes if they sell shares of a mutual fund. For example, if you sold $10,000 worth of mutual fund shares, you would owe capital gains tax on that amount.
• Embedded Gains: Mutual funds that sell stocks or bonds for a gain pass on these capital gains to fund owners. For example, if the fund sold $10,000 worth of stock, you would owe capital gains tax on that amount even if you didn’t sell your shares.

The COVID-19 outbreak has sparked panic-selling on the part of fund owners. As fund owners sell, money managers must sell investments in the mutual fund to generate the cash needed to pay those investors. These redemptions trigger capital gains taxes that are passed on to the remaining fund owners that haven’t sold anything.

This is where tax-managed funds come in. They are designed to minimize taxable distributions and embedded year-end capital gain distributions. They aim to pay little to no capital gains and can help investors reduce their tax burden.

Some ways they reduce tax exposure include:

• Tax Loss Harvesting: The funds sell losing positions on a regular basis to realize losses that can be used to offset capital gains in other parts of the portfolio.
• Tax-Advantaged Securities: Municipal bonds generate interest payments that aren’t subject to federal income taxes, which reduces the overall portfolio’s tax burden.
• Investor Control: Tax-managed funds enable investors to control when they realize capital gains, such as during a low-income tax period when their tax rates will be lowest.

Some popular tax-managed funds include:

• Vanguard Tax-Managed Small Cap Fund Admiral (VTMSX)
• T. Rowe Price Tax-Efficient Equity Fund (PREFX)
• Vanguard Tax-Managed Capital Appreciation Fund Admiral (VTCLX)
• Russell Tax-Managed U.S. Mid & Small Cap Fund (RTSCX)

Mutual funds and how they are taxed

Mutual funds are taxed in a variety of ways, depending on the type of distribution received, the duration of the investment holding, and the type of investment. Most distributions received from a mutual fund must be declared as investment income on yearly taxes. However, there are different types of distributions, which are taxed at different rates.

Types of Distribution

• Ordinary Income: The highest rate of tax. This is the default rate for distributions from investments held for less than a year.
• Capital Gains: A lower rate of tax. This rate applies to distributions from investments held for 12 months or more.
• Tax-Free: Some distributions are completely tax-free.

Mutual Fund Distributions

Mutual funds distribute income in several ways:

• Dividends: Mutual funds distribute dividends when underlying assets pay earnings or interest.
• Capital Gains: Mutual funds pass on capital gains to fund owners when stocks or bonds are sold for a gain.
• Other Income: Mutual funds also distribute other income and payouts to shareholders.

Timing

The timing of buying and selling mutual funds can have a significant impact on taxes. If you buy shares in a fund just before a distribution occurs, you will have to pay tax on any gains incurred from shares throughout that year, even though you did not own the shares for the entire year.

Tax-Managed Funds

Tax-managed mutual funds are a way to avoid surprise taxes while still holding mutual funds in taxable accounts. These funds focus on minimizing capital gains distributions using a variety of tax strategies, such as tax loss harvesting, tax-advantaged securities, and investor control.

Tax-efficient equity funds and their investment objectives

Tax-efficient equity funds are a type of investment vehicle that aims to minimize the taxes an investor owes on their returns. They are designed to reduce the impact of taxes on investment portfolios, leaving more money available for growth and compounding.

Tax-efficient equity funds, or tax-managed funds, aim to pay little to no capital gains tax. They do this by employing a variety of strategies to minimize taxable transactions within the fund. Some of these strategies include:

• Tax loss harvesting: Selling losing positions regularly to offset capital gains in other parts of the portfolio.
• Tax-advantaged securities: Investing in municipal bonds, which generate interest payments that are exempt from federal income taxes.
• Investor control: Enabling investors to control when they realize capital gains, such as during a low-income tax period.
• Selling some stocks at a loss: Offsetting other gains by selling certain stocks at a loss.
• Eliminating wash sales: Avoiding selling and quickly repurchasing the same asset to claim a tax loss.
• Scrutinizing tax lots: Analyzing the history of purchasing a stock over the years and selling the tax lots with the highest cost basis.
• Evaluating dividend-paying stocks: Choosing stocks that offer dividends taxed at more favorable rates.

The objective of tax-efficient equity funds is to generate returns through fund price increases while avoiding annual capital gain distributions. They aim to provide returns similar to non-tax-managed funds while also minimizing taxable transactions within the fund.

It's important to note that while tax-efficient equity funds can help reduce tax obligations, investors should also consider their long-term financial goals and not make investment decisions solely based on tax considerations.

The impact of taxes on investment portfolios

Taxes can have a significant impact on investment portfolios, and it is important for investors to understand how taxes can affect their returns. Investment taxes are triggered by different types of gains and distributions, and if not carefully managed, a meaningful amount of returns can be lost to taxes.

Types of taxes on investments

There are several types of taxes that can impact investment portfolios:

• Capital gains taxes: Taxes levied on the profit made from selling an investment. The tax rate depends on how long the investment was held, with short-term capital gains (held for one year or less) typically taxed at a higher rate than long-term capital gains.
• Dividend taxes: Taxes on dividends received from investments. These can be qualified dividends, taxed at the lower capital gains tax rate, or non-qualified dividends, taxed at the higher ordinary income tax rate.
• Embedded gains taxes: Taxes on gains passed on to investors when the fund itself sells stocks or bonds for a gain. These gains are distributed to investors each year and are taxable even if the investor did not sell any shares.

Tax-managed mutual funds

Tax-managed mutual funds are designed to minimize the tax burden on investors by reducing taxable transactions within the fund. They aim to generate returns through price increases while avoiding annual capital gain distributions. Some strategies used by tax-managed funds to reduce taxes include:

• Tax loss harvesting: Selling losing positions to offset capital gains in other parts of the portfolio.
• Investing in tax-advantaged securities: Such as municipal bonds, which generate interest payments that are not subject to federal income taxes.
• Giving investors control over when they realize capital gains: For example, enabling them to sell during a low-income tax period when tax rates are lowest.

Strategies for minimizing taxes on investment portfolios

• Invest in tax-efficient funds: Tax-efficient funds, such as tax-managed mutual funds, are managed with the goal of limiting capital gain distributions by keeping holdings turnover low and harvesting losses to offset gains.
• Hold investments for the long term: Long-term capital gains are typically taxed at a lower rate than short-term capital gains.
• Invest in tax-advantaged accounts: Such as IRAs and 401(k)s, which offer tax benefits such as tax-deferral or tax-exemption.
• Be mindful of the timing of purchases and sales: Buying after a dividend or capital gain distribution can help avoid paying taxes on those distributions. Selling before a distribution can result in a lower capital gains tax rate.
• Consult a tax professional: Calculating taxes on investments can be complex, and a tax professional can help ensure accurate reporting and compliance.

Strategies to minimise taxable transactions

There are several strategies that can be employed to minimise taxable transactions. Here are some detailed, direct, and instructive strategies with a focus on tax-managed mutual funds:

• Tax Loss Harvesting: This strategy involves selling losing positions regularly to realise losses that can be used to offset capital gains in other parts of the portfolio. By doing so, investors can reduce their overall tax liability.
• Tax-Advantaged Securities: Municipal bonds, also known as "munis," generate interest payments that are generally not subject to federal income taxes. By including these securities in their portfolios, investors can reduce their overall tax burden.
• Investor Control: Tax-managed funds allow investors to control the timing of realising capital gains. For example, they can choose to realise gains during periods of low income tax, resulting in lower tax rates.
• Holding Mutual Funds in Tax-Advantaged Accounts: One of the most obvious strategies to minimise taxable transactions is to hold mutual funds in tax-free or tax-advantaged accounts, such as a Roth IRA or 401(k). These accounts offer tax benefits that can help reduce an investor's tax liability.
• Timing of Buying and Selling Mutual Funds: Investors should consider the timing of their transactions. It is generally recommended to buy into a mutual fund after the ex-dividend date to avoid paying taxes on dividends and capital gains accrued before becoming an owner. Similarly, selling before the ex-dividend date can result in a lower capital gains tax rate.
• Maximising Retirement Accounts: Contributing to retirement accounts, such as 401(k) or IRA, can help reduce taxable income. These contributions are often made with pre-tax dollars, lowering an individual's taxable income for the year.
• Utilising Health Savings Accounts (HSAs): HSAs offer tax advantages, especially for those with high-deductible health insurance plans. Contributions to HSAs can be made through payroll deductions, excluding them from an individual's taxable income. Additionally, withdrawals from HSAs are not taxed when used for qualified medical expenses.
• Claiming Tax Credits: Tax credits can provide significant tax savings. Examples include the Child Tax Credit and the Earned Income Tax Credit (EITC). These credits directly reduce the amount of tax owed to the IRS, offering a dollar-for-dollar benefit.
• Long-Term Capital Gains: Holding investments for the long term can result in preferential tax rates. Capital assets held for more than a year are typically taxed at lower rates than those held for a shorter duration.
• Deferring Income: Deferring income from one year to the next can reduce taxable income in the current year and delay the payment of taxes. However, it is important to consider the potential tax implications in the following year, especially if there is a change in tax brackets.

Frequently asked questions