With mutual funds, your tax consequences are largely fixed at the time you buy your shares. When the fund’s income distribution check arrives in themail or is reinvested, a fund’s gain or loss per share has become your per share gain or loss. And your tax return has to reflect it. The time to make tax moves is before you invest in a fund. By followingthese simple guidelines in this article, you’ll be able to minimize the income taxes you pay on your mutual fund investments.

Keep Distribution Timing In Mind

First find out the fund’s distribution timing before you invest. Mutual fundsmust distribute most of their net income to their shareholders every year.

What happens if you buy taxable fund shares soon before the fund’s record date for a distribution? Your distribution will include some of the money you just invested. And when your investment money comes right back to you, itwill have become taxable income. You need to check a fund’s distributiondate before you invest. If it’s close, just delay your purchase until after therecord date. By carefully managing your purchase timing, you can avoidbeing caught in the distribution date tax trap.

Be Alert To Turnover Ratios

A fund’s prospectus reports its turnover ratio, which measures the percentage of the fund’s portfolio that its managers sell annually. Somefunds have a high annual turnover ratio, which tells you they may be generating significant capital gains. When the gains are distributed, theybecome taxable shareholder income.

Other funds with a low turnover ratio tend to hold onto their investments longer, letting earnings compound without selling and realizing taxable capital gains. If you evaluate a fund’s turnover ratio before you invest, you caninclude the taxable capital gains that are likely to be realized by the fund in your decision making.

Look At Tax-Exempt Funds

If you invest for current income and you are in a high tax bracket, investing in tax-exempt funds may be a sound tax strategy. Your after-tax returnfrom a fund of municipal bonds whose income is exempt from federal income tax may be higher than the after-tax return from a taxable bond fund. Atax-exempt fund with a low expense ratio may yield the highest income.

Any investor who is subject to the alternative minimum tax needs to be very careful, however, because interest on certain “private activity bonds” is included in income for purposes of the alternate minimum tax.

Use Any Foreign Tax Credits

The tax law provides a benefit if a fund reports it made foreign tax payments. Funds may have to pay income taxes to foreign countries withrespect to income on foreign securities they invest in. The proportionalshare of those taxes which funds report to you can be claimed as a credit or an itemized deduction on your federal income tax return. The credit, whichreduces your tax, may require a separate form. The deduction, whichreduces your taxable income, goes on Schedule A1 Line 8 “Other Taxes.” Youshould compare the effect of both the credit and deduction alternatives before you finalize your return.

Make A Careful Basis Choice For Capital Gains/Losses

The cost basis you use to report capital gains and losses from selling mutual fund shares can affect the taxable amount of your transaction. Todetermine a capital gain, you generally calculate the difference between the selling price of your shares and their cost. What if you don’t sell all yourshares and you paid different prices at different times, such as through a dividend reinvestment plan? Any automatically reinvested dividends should be included in your cost basis. So, you always need good records ofreinvested dividend amounts. In this partial sale situation, you can use oneof several methods for identifying the shares sold and calculating your cost basis. One may be more favorable than others. It may be wise to contactyour Financial Advisor about making the decision of which method of basis calculation is right for you.

ALAN S. MOORE, who writes his column every Wednesday for L’Observateur,is a financial advisor of Legg Mason Wood Walker Inc., a diversified financialservices and securities brokerage firm that is a member of the New York Stock Exchange and SIPC.

Back to Top

Back to Business Headlines

Copyright © 1999, Wick Communications, Inc.

Best viewed with 4.0 or higher