How to Tax Manage Your Own Funds
Mutual fund companies started marketing so-called ‘tax-managed’ funds in the 90s as a way for investors to save on taxes. You can use their techniques to manage (read minimize) taxes on your own.
Tax-managed funds are actively managed funds, with all the negatives that come with being actively managed, but they’re specifically geared to limit capital gains taxes that are passed from the fund to investors. At the end of the year, mutual funds are required to distribute capital gains to investors. Those investors, in turn, pay taxes on those gains. No one likes paying taxes, so a whole group of funds has sprung up to fill this niche.
Tax managed funds employ four main strategies to minimize taxes:
- Minimize taxes when selling by keeping your basis in mind. Assuming your fund purchase was not a one-time event, you own different amounts of shares purchased at different prices. When you sell, it makes sense to specify that the shares being sold be those with the highest purchase price. This way, your capital gain is minimized or you might even have a loss that can offset other taxable gains elsewhere. Doing this is somewhat complicated and records-intensive, however. You must tell the fund company specifically which shares (by date) you want sold. Moreover, once you utilize this method, you’re stuck with it. You can’t later go back to ‘average cost basis.’
- Keep turnover low. Buying and selling generates taxes. Period. Keeping trades to a minimum lowers your tax bill.
- Match losses with gains. As alluded to above, capital gains are offset by capital losses. In other words, if one investment lost money upon sale, you can use that loss to lower your capital gains elsewhere.
- Buy stocks with low or no dividends. Dividends are taxed at 15% for most people. You don’t pay that 15% if you have no dividends to begin with.
You can employ each of the above techniques on your own to limit your tax bill. It depends on your situation, but for most people, only the first technique results in a sizable benefit. You shouldn’t make buy/sell decisions based on taxes, so gain matching and turnover are unlikely to help much.
There’s an important caveat to using the first technique, however. By employing this technique, you’re ‘back loading’ all your capital gains. So when you ultimately sell the last shares, they will be the absolute cheapest and your gain could be huge.
