Tax-Smart Strategies for Mutual Fund Investors

It's easy to overlook tax considerations when investing in mutual funds. But with a little knowledge and care, you can avoid common — but potentially costly — tax traps.

Avoid Year-End Purchases

Mutual funds typically distribute accumulated dividends and capital gains toward the end of the calendar year. It's wise to avoid investing in a fund shortly before such a distribution because you'll end up paying taxes on gains you didn't share in.

It's actually a common misconception that investing in a fund just before a distribution date is like getting "free money." True, you'll receive a year's worth of income right after you invest. But the value of your shares will immediately drop by the same amount, so you won't be any better off. Plus, you'll be liable for taxes on the distribution as if you had owned your shares all year.

You can get a general idea of when a particular fund anticipates making a distribution by checking its website periodically. It's also important to make a note of the "record date" — because investors who own shares of the fund on that date will participate in the distribution.

Invest in Efficiency

When it comes to tax efficiency, not all funds are created equal. Actively managed funds tend to be less tax efficient because they buy and sell securities more frequently, which generates a greater amount of short-term capital gain that's taxable at ordinary income rates.

To reduce your tax liability, consider investing in tax-efficient funds, such as index funds, which generally have lower turnover rates. Also available are also non-index funds that are "passively managed" (sometimes described as "tax managed" funds), which are designed to minimize taxable distributions.

Another option is exchange-traded funds (ETFs). Unlike mutual funds, which generally redeem shares by selling securities, ETFs are often able to redeem securities "in kind" — or swap them for other securities. This limits an ETF's recognition of capital gains, making it more tax efficient.

This isn't to say that tax-inefficient funds don't have a place in your portfolio. In some cases, actively managed funds may offer benefits, such as above-market returns, that outweigh their tax costs.

Watch Where You Hold Them

If you invest in actively managed or other tax-inefficient funds, try to hold them in nontaxable accounts. These include traditional IRAs or 401(k) plan accounts.

Because earnings in such accounts are tax-deferred, distributions from funds they hold won't have tax consequences until you withdraw them. And if the funds are held in a Roth account, those distributions will escape taxation altogether.

Track Your Basis

Many investors elect to have their distributions automatically reinvested in their funds. But it's important to remember that those distributions are taxable regardless of whether they're reinvested or paid out in cash.

Reinvested distributions increase your cost basis in a fund, so it's critical to track your basis carefully to avoid double taxation. If you fail to account for these distributions, you'll end up paying tax on them twice — once when they're paid and again when you sell your shares in the fund.

Fortunately, under current rules, mutual fund companies are required to track your basis for you. But you still may need to track your basis in funds you owned before 2012, when this requirement took effect. Also, even if a fund is tracking your basis, there are several accounting methods available, and it's important to elect the one that's most effective for you.

Look Back — and Forward

Before investing in a mutual fund, look at its history of making taxable distributions, its tax-cost ratio and other data that reflect its tax efficiency. But don't assume that a fund that historically has been tax efficient will always be that way. Monitor your funds for changing circumstances that could result in larger taxable distributions in the future.