We all know that mutual funds can grow your initial investments. We know, too, that they are relatively safe investment vehicles. The securities included in the best mutual funds are spread out over a wide variety of types – everything from stocks and bonds to commodities – which means that investors’ dollars are diversified. Diversification is still the key to sound investing.
But what about taxes? Can mutual funds save you money on taxes? Or will they somehow make you pay more in taxes every year?
As with most investing questions, the answer to all three of these questions is a solid “it depends.”
Most investors want what is known as a tax-efficient mutual fund. This type of fund protects its investors from paying taxes while they own it. This is important because there are times, albeit rare ones, when both mutual funds and exchange-traded funds (EFTs) will produce taxable income. This income usually comes as either dividends or capital gains.
Consider the way ETFs work: If one of these funds includes a stock that pays a dividend, that dividend moves on to the EFT’s shareholders. The investor may then owe taxes on this dividend. On the other hand, if a mutual fund sells the most successful stocks it owns during the year, it may create a taxable gain. This gain moves to the fund’s investors, who are then responsible for the taxes on this gain.
The most tax-efficient mutual funds or ETFs try to avoid these scenarios. There is little these vehicles can do to avoid taxable dividend income. You don’t want your mutual fund or ETF to avoid all of the stocks that pay dividends. Many of these stocks, after all, are top performers. You’ll just have to accept the dividend taxation issues as part of the cost of investing.
Funds, though, can take steps to avoid capital gains. Investors should look or funds or ETFs that have a long history of not creating capital gains distributions. Usually, these are the funds with the lowest turnover ratios.
Mutual funds, then, won’t necessarily save you money when it comes to taxes. But if you invest in the right funds, or ETFs, you must might be able to avoid any unnecessary taxation. Remember to do your homework before sinking your dollars into any fund or ETF. The investment vehicle’s history of capital gains distributions is just one more factor that investors have to consider.