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Mutual Fund Tips
Consider Taxes When Picking Mutual Funds
by InvestorGuide Staff (Write for us!)
(Click on the links within the article to get definition of that word)
The principle advantage of a mutual fund investing strategy is reduced risk. By spreading the capital out over a number
of investments, the risk of loss decreases. The more diversified the mutual fund, the lower the chances for a loss.
Of course, a more diversified portfolio also reduces chances of big gains as no single winner will affect the overall
earnings significantly. However, several mutual funds posted huge profits during the 1990's and beyond which is why
they remain so popular with investors.
However, one of the dirty little secrets about mutual funds is really no secret at
all: you have to paycapital gainstaxes when you cash out. The reason why the average investor fails to consider taxes when purchasing or selling mutual
funds is because most brokers could care less. Brokers are trying to make money like everyone else and they are more
concerned about commissions - the taxes on capital gains are the investor's problem.
But the investor needs to consider tax liabilityissues when buying a mutual fund because tax effects are certain
and very predictable - the next big winner is not. This is why the investor should always consider the tax efficiencyratio of a mutual fund. The tax efficiency ratio will tell the investor what percentage of the pretaxreturn the investor
was able to hold onto once taxes were paid. The tax efficiency ratio is not provided by the mutual funds but can be
found from a number of investment services that have begun computing this ratio. The higher the ratio, the more money
the investor keeps of the original pretax earnings once taxes are assessed.
But for the individual investor without a massive portfolio and the luxury of paying money managers, there are some
ways to minimize capital gains while maximizing profits. Where mutual funds are concerned, it is important to understand
the realized capital gains of the portfolio.
Depending on the mutual fund, it is common for there to be a capital gains distribution every year or in regular
intervals. This is essentially like a cashpayout for a stock dividend. Basically, the mutual fund is sharing a
portion of the profits with investors. And just like a dividend, the capital gains distribution is income and must be
taxed.
An investor is encouraged to ask about the realized capital gains because if they are in excess of 5 percent and
the capital gains distribution is near, it may be better to hold off buying until after the distribution. To understand
why, consider the following example:
Assume that an investor was considering purchasing 1,000 shares of a mutual fund for $20 each and the date is
December 28th. January 1st is the record date and when the mutual fund will have a capital gains distribution of
$2/share, or 10% realized capital gains. Now the investor will have invested a total of $20,000 and own 1,000 shares
if he/she were to buy the mutual fund on December 28th - and the investment will be worth $20,000. However, for
this
investor, the distribution of the investment will change in the New Year: the share price of the mutual fund will drop
to $18 after the capital gains distribution (barring any changes due to marketinfluence). Thus, the 1,000 shares are
now worth $18,000 and the capital realization is $2,000 - the investor must now pay taxes on this $2,000. By the time
taxes are paid and fees assessed, it will probably end up costing this investor more if the mutual fund is bought on
December 28th as compared to making the purchase on January 2nd when the tax liability could have been avoided.
Of course, the capital gains distribution will not be of great importance if you are only making minimal investments
at regular intervals. However, for an investor looking to make a lump sum investment, the record date and realized
capital gains percentage will play an important part in when and how much is paid in taxes.
It is also possible for an investor to lower their realized capital gains from selling a profitable mutual fund by
also selling a losing fund at the same time. Unless there is some genuine hope for recovery of a losing fund, it is
better to use it to help lower tax liability than to hold onto it for a turnaround that may never come. Remember, tax
liability is certain while a sudden change in fortune for a losing fund is but a dream!
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