How Fund Investment Strategies May Affect Your Taxes
There are several ways an investment can impact your tax bill. Choose the right investment for your taxable accounts and make sure you understand the tax implications.
It’s important to choose the right investment for your taxable accounts because there are several ways an investment can impact your tax bill: the kinds of securities the fund invests in, the portfolio's turnover rate and the fund's investment policies. All these factors can come together to create capital gains and income dividends that are taxed in varying ways.
What is a capital gain?
Mutual funds invest in a variety of securities and when they sell those securities at a higher price, they realize a profit. They pass these gains onto shareholders in an annual distribution.
- Short-term gains are made when an investment is sold within the first year of purchase, taxed at a rate of up to 35%.
- Long-term gains are from investments that are held longer and are taxed at a lower rate of 15%.
Further, when you sell your shares, you may realize a profit (or loss). If you make a profit on some investments, and a loss on others, you may be able to use those gains to offset your losses and pay lower taxes. If your losses are more than your gains, you may be able to apply those losses against other income, up to $3,000.
What is an income dividend?
Many investments, typically bonds but some stocks as well, pay income to shareholders, called dividends. Any interest income generated by securities in a fund's portfolio is paid to shareholders on a per-share basis at regular intervals, typically monthly or quarterly.
- Qualified dividends are typically taxed as long-term capital gains.
- Ordinary or non-qualified dividends generally include all taxable income except long-term capital gains and are taxed at your income tax rate.
- Tax-exempt interest income from municipal bonds is generally exempt from federal income taxes. State and local municipal bonds may be exempt from state and/or local taxes.
What are the chances your fund will generate taxable income and capital gains?
|Type of Fund||Potential for Federal Taxable Income||Potential for Capital Gains|
|Taxable money market||High||Very Low|
|Tax-exempt money market||Very Low||Very Low|
|Tax-exempt bond||Very Low||Low|
|Balanced (stocks and bonds)||Medium to High||Medium to High|
|Growth and income stock||Medium to High||Medium to High|
Money market funds1 pay ordinary dividends. Whether these dividends are taxable depends on the nature of the underlying investments: municipal securities produce income that is generally not subject to federal income tax and, in a state-specific fund, may also be exempt from state and local taxes. Because money market funds own only short-term securities, which are normally held to maturity, they do not ordinarily generate capital gains or losses.
Bond funds typically produce higher levels of income dividends (which may be taxable in whole or in part, depending on the fund’s investments). Further, because the prices of bonds fluctuate in response to changing interest rates as well as credit risk, it is possible to have taxable capital gain distributions from bond funds, even tax-exempt bond funds.
Stock funds may pass along ordinary income from dividends paid by stocks as well as capital gains from the sale of stocks. Because stock prices can fluctuate considerably more than bond prices, you are more likely to realize a larger capital gain (or loss) when selling shares of a stock fund. Further, certain investments and strategies can lead to potentially larger gains. To help gauge the potential tax impact, know your fund's objective and investment strategy:
- Older, larger and well-established companies tend to rise in price more steadily over the long term, whereas newer or smaller companies can be more volatile and experience wider or more accelerated jumps in price.
- Growth funds, which look for companies that managers believe will experience faster than average growth, tend to offer a higher potential return and perhaps higher capital gains. Funds that concentrate on value stocks buy when prices are depressed with the expectation of significant growth. They tend to produce more current income than growth funds and, should the market recognize the true value of the stocks in which they invest, potentially high capital gains.
- Some funds have a high portfolio turnover rate, actively buying and selling shares. Frequent selling can make the fund more likely to produce annual taxable distributions than one that follows a "buy-and-hold" strategy.
1. An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation, or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in a money market fund. As a measure of current income, seven-day yield is more reflective of the fund's income-generating ability than total return.
This information is general in nature and is not intended to constitute tax advice. Please consult your tax advisor for more detailed information on tax issues and for advice on your specific situation.
Investors should consider the investment objectives, risks, charges, and expenses of a mutual fund carefully before investing. Download a prospectus, or summary prospectus, if available, that contains this and other information about a fund, and read it carefully before investing.