We know you're all good, apple-pie-eatin', Mom-lovin', gas-guzzlin' Americans, but patriotism doesn't mandate that you pay more in taxes than necessary. Unfortunately, that might be what you're doing, according to a study last year by mutual fund info-snooper Lipper.
According to the study, almost one-fourth of the typical mutual fund's returns are consumed by taxes. We're talking about the capital gains and income distributions made by funds each year to shareholders. When you sell the fund, you'll have to pay additional capital gains (assuming you made a profit, which -- historians tell us -- did happen in the stock market sometime ago).
But don't despair, all ye fund-lubbers. Thanks to the Mutual Fund Tax Awareness Act of 2000 (which didn't take effect until 2002), fund families must provide the after-tax returns in their prospectuses. These returns will be based on the top tax bracket, so those numbers won't be as bad for most people. And if the fund is in a tax-friendly account such as an IRA, taxes aren't a consideration at all.
But if you have mutual funds in a taxable account, here are some ways to keep more of your money by giving less to Uncle Sam:
Invest in index funds: Not only do index funds charge virtually nothing in fees (0.2% to 0.4%, compared to the industry average of 1.25%), but the turnover is very low.
Choose individual stocks: If you're comfortable evaluating businesses, then buying and holding the stocks of good companies is very tax-efficient. It can also be cheap, if you use a discount broker or a dividend reinvestment plan.
Look for tax-efficient funds: These are funds that seek to mitigate the damage wreaked by taxes. According to the Lipper study, the after-tax returns of tax-efficient funds led the pack in many categories.
Keep funds in IRAs: If you're infatuated (trust us, it's not love) with a fund that has a so-so after-tax record, keep it in an IRA, where earnings are tax-deferred or tax-free (depending on if it's a traditional IRA or a Roth, respectively).
- Don't invest in a fund right before distributions: It doesn't matter how long you've held the fund; if you're an owner on distribution day, you'll have to pay the taxes, even if you got in just a week before. Call the fund family and inquire about distribution plans before investing. Most funds distribute income and capital gains toward the end of the year, but distributions occur at other times, too.
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