Tax Strategies for Mutual-Fund Investors

Mike Piper for the Wall St Journal writes: What’s your most important tax advice for mutual-fund investors?

MIKE PIPER: By definition, tax planning is a case-by-case sort of thing, so it’s almost impossible to give a single piece of advice that would be helpful for everyone.
For mutual-fund investors who are investing via taxable brokerage accounts, the general goal is to lose as little of your return to taxes as possible. Strategies to consider would include:

• Making sure to tax-shelter your tax-inefficient funds (e.g., taxable bond funds with high yields, stock funds with high turnover, REIT funds) by holding them in 401(k) or IRA accounts before tax-sheltering your more tax-efficient funds.
• If you have to hold bonds in a taxable account, checking to see whether muni funds offer a yield that’s as high or higher than the after-tax yield on taxable bond funds with a comparable level of risk.
• Paying attention to tax-loss harvesting opportunities (or tax-gain harvesting, if you’re in the 10% or 15% tax brackets). These days with the multitudes of index funds and ETFs available, it’s generally very easy to find a suitable replacement for your portfolio after selling a fund to harvest a loss.

Most people, however, are not maxing out their retirement accounts. So, for them, tips for taxable account investing aren’t as relevant as tips for getting the maximum value possible from their retirement accounts. Things that will generally help in that regard would include:

• Not doing any saving for retirement via taxable brokerage accounts until IRA and 401(k) accounts are maxed out.
• Carefully considering whether Roth savings, tax-deferred savings, or a combination of the two is most likely to be advantageous.
• Resisting the temptation to cash out a 401(k) and spend it after switching jobs.
• Checking whether they’re eligible for the retirement savings contribution credit (or whether a modest pretax IRA or 401(k) contribution would make them eligible). 
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• GREG MCBRIDE : What’s your most important tax advice for mutual-fund investors?  Don’t let the tax tail wag the investment dog, meaning, don’t make investment decisions solely based on tax considerations. That being said, it is certainly prudent to invest in a tax-smart and tax-efficient way, by maximizing tax-advantaged retirement savings options such as 401(k)s and individual retirement accounts, on a Roth and/or tax-deferred basis, as suits your situation.
  Also, where you park certain investments can enhance your tax efficiency and net returns, by putting higher-taxed collectibles such as precious metals funds and income-producing bond funds in a tax-advantaged account, and holding those investments prone to long-term capital gains in a taxable account. Using any capital losses to offset short-term capital gains and up to $3,000 of income can also be a prudent strategy.
•  LARRY ZIMPLEMAN: What’s your most important tax advice for mutual-fund investors?  My most important tax advice would be to not be overly driven or focused on tax considerations at the expense of the long-term return of the portfolio. You always want to have the long-term return of your mutual fund portfolio be the #1 priority, and tax considerations would be #2.
  
  Remember, many of your investments–such as 401(k) accounts–are tax preferenced, so tax considerations are not an issue during the accumulation period. Make sure you have a financial or tax adviser who can offer you some insights on tax considerations–but never let that be a driver of your investment decisions.
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•  ELEANOR BLAYNEY: What’s your most important tax advice for mutual-fund investors?  It can be difficult to be tax-efficient using mutual funds as a result of two types of capital gains that are taxable to investors.
  
  The first type is straightforward and can be controlled by the investor–namely, the gain realized when the investor sells shares of the mutual fund at a higher price than when they were purchased. The second, however, is not as controllable: These are the annual capital-gain distributions that open-ended mutual funds are required to pay out in the year of their realization.
  
  The cost basis for these distributions do not reflect an investor’s purchase price, but instead are based on the fund’s internal purchases of given securities. Thus it is possible for an investor to have to pay taxes on gains that he never experienced. The most egregious example is when an investor purchases a fund today for $100 a share, and the fund then makes a $20 capital-gain distribution the following day. The NAV of the fund drops by a corresponding $20 to $80 a share, leaving the investor having to pay capital-gains taxes on a portion of his own contributed principal.
  
  The moral here: Before buying into a mutual fund, check on the fund’s distribution dates.  Buy after, not immediately before, the distribution.
  
  A certified financial planner professional with expertise in investment management can advise you on the tax implications of mutual funds. He or she can help you not only with your asset allocation in a portfolio of funds, but also with “asset location.” This involves determining which funds to put into your taxable accounts, and which are better held in your tax-deferred accounts, as part of an overall strategy to maximize your after-tax returns.
  
   CHRISTIAN MAGOON: What’s your most important tax advice for mutual-fund investors? Taxes in the U.S. appear likely to rise in the coming years. That is why it is more important than ever for investors to make sure they are maximizing tax-efficient vehicles and investment strategies within their portfolio. Tax-efficient mutual funds or the tax-advantaged structure of an exchange-traded fund are two simple ways to keep more investment gains.
  
  GEORGE PAPADOPOULOS: What’s your most important tax advice for mutual-fund investors? If you are getting ready to make a mutual-fund purchase, please check the mutual-fund company’s website to learn its year-end distribution dates. You should delay the purchase after this date (called the ex-dividend date) to avoid paying more taxes on an investment you just made.
  
  In addition, with the substantial recent market gains, if you are charitably inclined, do not sell the stock or mutual-fund shares first and then donate the cash. Instead, make arrangements with the particular charity to donate the appreciated shares. In this way, you will avoid paying taxes on the capital gains (assuming you have held the shares for more than a year) and at the same time receive a tax deduction equal to the appreciated value of the shares.
  
   GUS SAUTER: What’s your most important tax advice for mutual-fund investors?  Since taxes are inevitable, and likely to become even more inevitable, investors should focus on after-tax returns. You can’t live off of before-tax returns.
  For equity investors with a long time horizon, it is important to search for funds that have low annual distributions of capital gains. Grinding through the math, it turns out that a fund that realizes and distributes most of its capital gains annually would have to outperform a fund that distributes minimal capital gains by as much as 2% per year in order to provide the same long-term, after-tax return.  Funds that have lower turnover are a pretty good place to start looking for low capital-gain distributions.  Index funds are an obvious candidate.
  For fixed-income investors in higher tax brackets, municipal-bond funds can be an attractive alternative to taxable bond funds.
  
  
  MATT HOUGAN: What’s your most important tax advice for mutual-fund investors?   You still own mutual funds? Really? Are you still watching Ghostbusters on your BetaMax?
  You shouldn’t own mutual funds in taxable accounts. They are fine products for tax-deferred accounts. They play a key role in my retirement portfolio.
  
  But in taxable accounts, actively managed mutual funds are a tax disaster.  Why?  Because each year, actively managed mutual funds pay out billions of dollars in capital-gains distributions to their shareholders…gains that you have to pay taxes on.
  
  What makes this so horrific is that often, you have to pay taxes based on someone else’s activity. Let’s say you own shares in the Matt Hougan Actively Awesome Mutual Fund. I’ve managed the portfolio well, and delivered 25% gains last year. But last month, someone else who owned 20% of all the shares in the fund sold their stake. I had to sell a bunch of securities to pay him in cash…securities that had appreciated in value.
  
  At the end of the year, our friend is sitting on a beach in Hawaii smiling. But by law, I have to pay out those capital gains to all the remaining shareholders in the fund. That’s right: You have to pay taxes because Mr. Aloha sold his shares.
  
  It’s fundamentally unfair and creates a huge drag on returns.
  Actively managed mutual funds are for retirement accounts; ETFs  (and maybe index mutual funds) are for taxable accounts. Just remember that and you’ll be OK.