Taxes have a way of eroding your investments, but if you invest in a tax-efficient manner, you can reduce your tax bill and therefore keep a larger portion of your investment returns.
What are Tax-Managed Funds?
Tax-managed funds are specifically designed to reduce taxes on your investments. This is done in several ways, whether by avoiding stocks that pay dividends, selling certain stocks at a loss to offset other gains, or holding stocks instead of selling them.
Two Types of Capital Gains
To understand what types of taxes you may face on your investments, it’s important to recognize the two types of capital gains that could be taxable for you.
Gains realized when selling fund shares
Any gains you realize from mutual fund shares while you own them are usually subject to tax. When you sell mutual fund shares for more than you paid for them, you will realize a short-term or long-term capital gain.
Embedded gains distributed annually
Within a mutual fund, when the fund sells stocks or bonds that have gained in value, that gain must be passed on to you as a fund shareholder. Even if you reinvest all of the capital gains and distribution dividends, you will still receive a 1099 form showing the amount of the gain, and you will have to report the gain on your tax return and pay the appropriate amount of tax.
How Tax-Managed Funds Reduce Embedded Distributions
A tax-managed mutual fund is designed to minimize embedded distributions. Within the fund, managers work to utilize losses to offset gains. The end result is that you see gains through an increase in the fund price, rather than through a larger amount of annual distributions. Since you control when you sell shares, you now control the tax year in which those gains will be reported.
Where to Find Tax-Efficient Funds?
Many investment fund companies offer funds specifically designed as “tax-managed.” For example, Vanguard offers a tax-managed balanced fund, an international fund, a small-cap fund, and others.
Even if you don’t choose a tax-managed fund, you can invest tax-efficiently using index funds and exchange-traded funds. Both options provide great ways to reduce your tax liability and keep more of your returns.
Source: https://www.thebalancemoney.com/how-tax-managed-funds-help-lower-your-tax-bill-2388989
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