Tax considerations can change as your circumstances and market conditions
change. Here are some ideas on how to lower your taxes when you buy and
sell shares in a mutual fund.
Buying
Before you buy mutual fund shares, ask about the realized gains in its
portfolio. If they're more than 5% of net asset value (NAV) and the record
date of the next capital gains distribution is near, you may want to delay
your purchase until after the record date. Otherwise you'll "buy the
dividend," and that can cost you money in taxes. Here's how it works.
Say you invest $5,000 on December 15 (record date), buying 250 shares
for $20 each. If the fund pays a distribution of $1 per share on December
16, its share price will drop to $19 (not counting market change). You
still have $5,000 in value (250 shares x $19 = $4,750 in share value, plus
250 shares x $1 = $250 in distributions), but you owe tax on the $250
distribution you received -- even if you reinvest it in more shares. To avoid
"buying a dividend," check a fund's distribution schedule before you
invest -- but keep it in perspective.
This rule of thumb primarily applies to large one-time, lump-sum
investments. If you make regular investments every month, don't let the
record date derail your program. It's better to buy the dividend than fail
to invest.
Selling
At some point, you may redeem shares from your taxable accounts and owe
capital gains tax on the profits.
When that happens, you can lower the net capital gains subject to tax by
selling shares from a fund that has lost value at the same time you sell
shares in a fund that has gained value. This will allow you to offset the
realized capital gains in the first fund with losses in the second. You can
also use this strategy to offset capital gain distributions. A common
mistake is to sell or exchange shares simply to avoid receiving a
distribution. For example, say you buy 1,000 shares of a fund that costs
$10 per share. Two years later, when the shares are worth $12 each, the
fund announces it will distribute a $1 long-term capital gain for each
share. You can stay in the fund and pay taxes on $1,000 in capital gains
distributions, or redeem your fund shares and pay taxes on a long-term
capital gain of $2,000.
As the table below shows, it may make sense to hold the investment and
pay taxes on the fund's distribution instead of selling your shares and
paying taxes on your capital gain.
Make sure you don't pay taxes twice. Be sure to include income and
capital gains distributions you've reinvested in a fund when determining
the cost basis of the shares you're selling. Calculating your cost basis is
one of the more complex aspects of tax reporting for your mutual fund
investments -- especially when you've bought shares of your fund at different
times.