Tax planning for mutual fund investments

Avoiding income by deferring year-end purchases

Mutual funds must pay out their gains and income to shareholders at least annually to avoid tax at the fund level. Income and balanced funds typically make taxable distributions to shareholders either monthly or quarterly, while equity funds normally make one annual distribution at or near the fund’s year end. These taxable distributions to shareholders reflect the income and net gains realized by the fund. In addition to this income, shareholders may benefit from unrealized gains on securities held by the fund and will recognize this income either when the fund disposes of the securities or the shareholder redeems their mutual fund shares.

Sometimes, a fund that appears to have a minimal or negative overall return for the year may actually make taxable distributions to shareholders because of gains the fund recognized on appreciation that occurred in prior years. From an investor’s standpoint, distributions do not result in additional return on their investment; instead, distributions are already reflected in the fund’s per–share value, so after a distribution is made, the per–share value is reduced accordingly.

Because of the income distributions mutual funds must make, the timing of when an investor purchases shares in a particular fund can affect their tax liability. Purchasing shares just before the record date (i.e., the date that determines which shareholders will receive the distribution) of a fund’s distribution is essentially purchasing a tax liability. This is because the price of the shares just before the distribution includes the income that is about to be paid out. When the distribution is made, the price per share falls, although the value of the shareholder’s total investment remains the same (i.e., if income is reinvested, the shareholder now owns more shares with a lower value per share; or if income is distributed, the cash received plus the value of the investor’s shares equals their investment before the distribution). Thus, investors in mutual funds should pay particular attention to when they invest in a fund. This is especially true for equity funds that make only one distribution each year.

Planning tip: Practitioners should advise clients planning to invest in a particular mutual fund to refer to the fund’s prospectus or contact the fund before investing to find out when it makes income distributions. Generally, investors should avoid purchasing shares in equity mutual funds in December since equity funds typically make annual distributions during that month.

Example 1.Untimely purchase of mutual fund shares results in “purchasing” a tax liability: H invested $15,000 in the ABC Equity Fund on Dec. 12, 20X1, when the price per share was $10. On Dec. 19, 20X1, the fund declared an income distribution of $1 per share to shareholders of record on Dec. 19, 20X1. On Dec. 26, 20X1, the fund distributed $1 per share, which reduced the price per share to $9. H’s $1,500 ($1 per share × 1,500 shares) distribution was automatically reinvested, resulting in an additional 166.67 shares ($1,500/$9 per share). H’s holdings in the fund before and after the distribution were as shown in the table, “Effect of Distribution on H’s Shares in Equity Fund,” below.

By purchasing the shares just prior to the record date of the distribution, H essentially purchased a tax liability on $1,500 of income. As shown in the table, although he owns more shares after the distribution, the total value of his investment is unchanged because of the lower price per share. The $1,500 distribution is taxable to H in 20X1 and is added to the basis in the shares he owns.

Variation: Had H purchased his shares after the Dec. 19 record date, he would not have recognized any income from the fund in 20X1.

Tax-efficient funds can minimize current taxes

A mutual fund’s tax efficiency refers to how the fund’s operations affect when income will be distributed and taxable to its shareholders. Tax efficiency can affect the overall net return a shareholder realizes from a fund and is often one of the factors shareholders consider when selecting mutual fund investments. Tax efficiency is more likely to be a factor in funds holding stocks and other equity instruments. It is not a concern when selecting mutual fund investments in retirement accounts like 401(k) plans and individual retirement accounts (IRAs) (and other tax–deferred accounts such as variable annuities).

Tax efficiency is essentially a function of a fund’s portfolio turnover rate. Turnover rate refers to how often a fund sells, or turns over, its portfolio of securities. Generally, funds with high turnover rates are less efficient than those with low turnover rates because it is the disposal of securities that causes the fund to recognize gain on an appreciated security. And because mutual funds must distribute virtually all of their income to shareholders each year, the more income a fund recognizes in a year, the more income shareholders must report for that year.

Generally, the more tax–efficient a fund is, the less current income a shareholder recognizes. In addition, many of the gains recognized by funds with high turnover rates are likely to be short–term rather than long–term and thus not eligible for a preferential capital gains rate.

Index funds tend to be more tax–efficient than other mutual funds. Stocks held by an index fund normally replicate a particular securities market benchmark (e.g., an S&P 500 stock portfolio). Thus, the fund is not actively managed like other funds with specific fund objectives. Index funds generally use a buy–and–hold approach to investing, selling securities only when cash is needed to redeem shareholders. They hold rather than sell appreciated securities so gains are unrealized rather than realized and recognized for tax purposes. Thus, index funds generally have a low turnover rate, which minimizes the current taxable income distributed to shareholders.

In addition to a lower portfolio turnover rate, index funds typically have lower management fees than actively managed funds. Over a long investment period, the combination of lower turnover and lower fees can significantly enhance an index fund’s overall return when compared to an actively managed fund.

As previously mentioned, a fund’s tax efficiency is not an issue when selecting mutual funds for retirement account assets such as IRAs and 401(k) accounts (and other tax–deferred accounts such as variable annuities). This is an important consideration when choosing investments for taxable versus retirement accounts. An individual wanting to invest in both actively managed and index funds will generally benefit by using the index funds for taxable investment assets and reserving the actively managed funds for retirement plan assets.

Some equity mutual funds are tax–managed funds. For these funds, minimizing taxes to shareholders by maintaining a low portfolio turnover rate and considering taxes when buying and selling securities is one of the fund’s objectives. These funds often charge a redemption fee to investors who withdraw funds before a specified length of time (e.g., one year). Practitioners with clients who want to minimize taxes through mutual fund investments might recommend that they consider tax–managed funds.

When choosing mutual fund investments, investors must consider the fund’s tax efficiency in view of their particular tax situation. Many investors will want to minimize their current taxes and defer gain recognition to a future year. This makes tax–efficient funds more appealing. However, investors with capital loss carryovers, excess investment interest, or other unused deductions may benefit from a fund with a high turnover rate that is more likely to generate more current taxable income. Of course, tax efficiency is only one factor in selecting a fund. The fund’s overall expected performance and whether it meets the investor’s personal financial planning needs are likely to be more critical criteria.

Example 2. Tax-efficient fund minimizes current taxes: J has $40,000 he plans to invest in a stock mutual fund. After analyzing the various funds that meet his objectives, he has narrowed the choice down to either the ABC Growth Fund or the ABC Index Fund. The Growth Fund is an actively managed fund with an annual portfolio turnover rate of 150%. The Index Fund is a passive fund that replicates the performance of the S&P 500 stocks. It has a very low portfolio turnover rate. J is in the highest ordinary income tax bracket and plans to invest in the fund for the long term.

If J would be satisfied with either fund, he should choose the Index Fund. Because it has a low portfolio turnover rate, much of the income he hopes to realize from his investment will be deferred until future years when he redeems his shares. The fund’s annual shareholder distributions should be less than those of the Growth Fund, which actually enhances the return of the Index Fund over the entire time he plans to hold it.

One of the disadvantages of investing in mutual funds is that, unlike holding individual securities, shareholders do not have total control over when unrealized gains will be recognized for tax purposes. In this regard, index funds and tax–managed funds typically provide shareholders with more control than actively managed funds because they have a lower annual portfolio turnover rate. Index funds and tax–managed funds may also be good alternatives to annuities or other retirement–oriented investments.

Selling shares before income distribution

Investors in mutual funds generally recognize income from funds in two ways: (1) ordinary income and capital gains resulting from fund distributions and (2) capital gain or loss from the sale or redemption of shares in the fund. Investors normally have no control over income distributed by the fund but can control when they recognize gain or loss from disposing of shares in the fund.

Mutual funds distribute both ordinary income and capital gains realized by the fund to shareholders. Short–term capital gains lose their capital gain character when distributed and are treated as ordinary income to the shareholders (Sec. 852(b)(2)).

Carefully timing when taxpayers sell shares in a mutual fund may enable them to convert ordinary income to long–term capital gain. Selling just prior to an income distribution (generally, based on the record date of the distribution) converts what would be ordinary income from the distribution to capital gain from the sale.

Example 3. Selling shares before income distribution: K owns 500 shares of Sky Income Fund, which she plans to sell before year end. The shares currently have a net asset value (NAV) of $25 per share. Her basis is $15 per share, and all of her shares have been held more than 12 months. The fund plans to make a $3–per–share distribution to shareholders of record on Dec. 18 (which will reduce the NAV to $22 per share ($25 − $3)). Of this amount, $2 will be ordinary income and $1 will be long–term capital gain.

If K waits until after Dec. 18 to sell her shares, she will recognize $1,000 of ordinary income and $500 of capital gain from the distribution plus $3,500 long–term capital gain from the sale ([$22 NAV per share after the distribution − $15 basis per share] × 500 shares sold).

If K sells the 500 shares on Dec. 17, she avoids the income distribution that includes the $1,000 of ordinary income. Instead, she recognizes a long–term capital gain of $5,000 ([$25 NAV per share − $15 basis per share] × 500 shares). Her total income is the same whether she sells before or after Dec. 18, but by selling before the income distribution, she converts $1,000 of ordinary income into long–term capital gain.

Individuals who plan to donate mutual fund shares to charity should do so before rather than after a distribution so they can avoid the distribution income on the donated shares.

Other mutual fund tax planning considerations

Unrealized portfolio appreciation/depreciation: A mutual fund’s prospectus includes information regarding the fund’s unrealized appreciation or depreciation in its securities portfolio. This information may give investors some insight into the future tax consequences of investing in the fund. Significant unrealized appreciation often generates recognized capital gains to the fund that, in turn, are distributed to the shareholders. Conversely, funds with little unrealized appreciation or unrealized depreciation in securities may generate less severe tax consequences to shareholders than those with significant unrealized appreciation, at least in the short term.

Contributor

Patrick L. Young, CPA, is an executive editor with Thomson Reuters Checkpoint. For more information about this column, contact thetaxadviser@aicpa.org. This case study has been adapted from Checkpoint Tax Planning and Advisory Guide’s Individual Tax Planning topic. Published by Thomson Reuters, Frisco, Texas, 2026 (800-431-9025; tax.thomsonreuters.com).