Many people overlook tax considerations when planning their mutual fund investments. Here are four tips that can help you improve tax efficiency and avoid costly tax traps:

1. Avoid year-end investments. Typically, mutual funds distribute accumulated dividends and capital gains toward the end of the year. It’s wise to avoid investing in a fund shortly before such a distribution. Why? Because you’ll end up paying taxes on gains you didn’t share in.

Don’t fall for the 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.

2. Invest in tax-efficient funds. When it comes to tax efficiency, not all funds are created equal. Actively managed funds tend to be less tax efficient — that is, they buy and sell securities more frequently, generating a greater amount of capital gain, much of it short-term gain 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, and “passively managed” funds (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” — that is, to 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.

3. Hold tax-inefficient funds in nontaxable accounts. If you invest in actively managed or other tax-inefficient funds, ideally you should hold them in nontaxable accounts, such as traditional IRAs or 401(k) plan accounts. Because earnings in these accounts are tax-deferred, distributions from funds they hold won’t have any tax consequences until you withdraw them. And if the funds are held in a Roth account, those distributions will escape taxation altogether.

4. Watch out for reinvested distributions. 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. (See “Accounting for cost basis.”)

Do your homework

It’s important to do your due diligence on the funds you’re considering, particularly for your taxable accounts. Examine a fund’s history of making taxable distributions, its tax-cost ratio and other data that reflect the fund’s tax efficiency. And don’t assume that a fund that historically has been tax efficient will stay that way in the future. Monitor your funds for changing circumstances that may lead to larger taxable distributions in the future.

Accounting for cost basis

If, like most people, you buy mutual fund shares at different times for different prices, the method you select to account for your cost basis can have a big impact on your tax bill. There are three methods to choose from:

First-in, first-out (FIFO). Under this method, it’s assumed that the first shares purchased are the first shares sold, but, if the value of your shares increases over time, this method will increase your taxes because older shares have a lower basis.

Specific identification. This method provides more control over the tax consequences of your transactions. Each time you sell mutual fund shares, you specify which shares are to be sold. It’s more work, but it enables you to select the shares that will provide the greatest tax benefits. Some mutual fund companies offer plans under which they select the shares that minimize your tax liability.

Average cost. This method typically generates taxes falling somewhere between FIFO and specific identification. On the plus side, it’s simple to use and has the advantage of distributing your tax liability evenly over time.

© 2017

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