Minimizing Taxes on Funds

Today’s article will enable you to understand how to select tax-friendly mutual funds when investing outside of retirement accounts. The key is to use tax-free money market and bond funds. Certain kinds of money market and bond funds invest only in bonds issued by governments, and depending on the type of government entity they invest in, their dividends may not be subject to state and/or federal tax. Such funds are typically identified by the word “Treasury” or “municipal” in their fund titles.

A Treasury fund buys federal government-issued Treasury bonds (also called Treasuries), and its dividends (although federally taxable) are free of state taxes. The dividends of a municipal bond fund, which invests in local and state government bonds, are free of federal tax, and if the fund’s investments are limited to one state and you live in that state, the dividends are free of state taxes as well.

The catch: Because everybody knows that Treasuries and municipal bonds are not subject to complete taxation, the governments issuing these bonds can pay a lower rate of interest than, say, comparable corporate bonds (the dividends on which are fully taxable to bondholders). Therefore, before taxes are taken into account, tax-free bond and money market funds yield less than their taxable equivalents. However, after taxes are taken into account, you may find that with tax-free money market or bond funds, you come out ahead of comparable taxable funds if your tax bracket is high enough. Because of the difference in taxes, the earnings from tax-free investments can end up being greater than what you’re left with from comparable taxable investments.

If you’re in the 28 percent federal bracket or higher, don’t buy tax-free funds inside retirement accounts. Your returns inside a retirement account are already sheltered from taxation. You can ignore the taxability of funds and go for the highest yields.

Unfortunately, stock mutual funds don’t have a tax-free version like bond and money market funds do. Unless they’re held inside a retirement account, stock fund distributions are always taxable, period. If you’re in a high enough tax bracket and a stock fund makes large distributions, these stock distributions can be a significant tax burden. Unfortunately, with stock funds more than any other type of fund, investors often focus exclusively on the pre-tax historical return, ignoring the tax implications of their fund picks.

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