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How to reduce and save taxes in investment - Tax Managed Mutual Fund

Updated on August 31, 2011

"When there's a single thief, it's robbery. When there are a thousand thieves, it's taxation"

I recently read an interesting study commissioned by Charles Schwab. The study found that a high-bracket tax payer who invested $1 in US stocks at the beginning of 1963 would have $21.89 at the end of 1992 (30 years), if invested in a tax-deferred account. Meanwhile, the same $1 would have grown to only $9.87 if invested in a taxable account (less than half as much).

In this article, I would like to share with you some tips on how to reduce tax in mutual fund investments.

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The profound impact of taxes on fund returns is a subject too long ignored
The profound impact of taxes on fund returns is a subject too long ignored | Source

How to save Tax in Mutual Funds

  1. Keep turn over low: Turn over rate indicates the amount of buying and selling activity that's done in a given year. Buying or selling funds in a taxable account generates capital-gain taxes (a capital gain occurs when a stock or bond is sold for a profit). Therefore, try to buy funds that could be held for longer term.
  2. Use tax-managed funds in taxable accounts: Tax-managed funds reduce or eliminate shareholder taxes by using a variety of tax-reduction techniques.
  3. Avoid short term gains: Short term capital gains are taxed as ordinary income at the shareholder's highest marginal income tax rate (up to 35% in 2005) , while long term capital gains enjoy a maximum tax-rate of 15% - almost half. Hence, hold mutual funds for more than 12 months.
  4. Buy fund shares after the distribution date: Mutual funds pay taxable distributions at least annually. If we buy a fund shortly before a distribution date, we will have to pay taxes on the distribution. If we wait until after the distribution date, the value of the purchase will still be same (assume no market change), but we can avoid the tax.
  5. Sell fund shares before the distribution date: There will be a small advantage in selling before the distribution date.
  6. Sell profitable shares after December: If you sell your shares in December, tax will be due with that year's return. So wait until January to sell.
  7. Harvest tax losses: This is selling losing securities in taxable accounts for the purpose of obtaining tax loses.

Tax-Loss Harvesting

In order to understand the concept of Tax-Loss Harvesting, imagine that it's December 2010. During the year you sold or exchanged funds for a $2000 profit. You have another fund with a $6000 loss.

Here is what you should do

STEP 1
Before the year end sell the losing $6000 fund
STEP 2
Use $2000 of the tax-loss to offset the $2000 gain on the profitable fund. This leaves a $4000 tax-loss balence
STEP 3
Use $3000 of the balance (maximum allowed in US) to reduce your income reported in the income tax-return.
STEP 4
The remaining $1000 balance will be the capital-loss carryover to 2011.

Now you may be curious how Tax-Managed funds reduces taxes.

  • Low turn over: They use index-oriented approach to take advantage of low cost (high return) and low turnover (fewer capital gains and hence lesser tax)
  • Use HIFO (High- in , First-out) accounting: Highest cost shares are sold first (thus keeping capital gains), which are passed through to shareholders , to a minimum.
  • Tax-Loss Harvesting: As explained above, loosing stocks are sold to accumulate tax-losses
  • Selecting low dividend paying stocks: Selecting stocks with few or no dividends will minimize annual share holder taxes.
  • Holding securities for long-term gains: As mentioned above, short term capital gains are taxed almost double the long-term gains.
  • Use redemption fees: Redemption fees is to discourage shareholders from selling profitable shares resulting in capital gains (and the capital gain tax)

Your fund managers of your Tax-managed Funds will do it for you, so you don't have to worry too much about it. However, it is important to understand how it works.

Reduce Tax Load using Tax-Harvesting

Source

A Textbook for Beginners in Investing

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