Sometimes saving money on taxes is as easy as choosing the right types of investments.
POINTS TO KNOW
- Investments that minimize trading activity and offset gains with losses will result in a lower tax bill.
- Some investments are exempt from taxation altogether.
Index mutual funds & ETFs
- Because index funds simply replicate the holdings of an index, they don't trade in and out of securities as often as an active fund would. Constant buying and selling by active fund managers tends to produce taxable gains—and in many cases, short-term gains that are taxed at a higher rate.
- Since index funds have to buy new lots of securities in the index every time investors put money into the fund, the fund generally has hundreds or thousands of lots to choose from when selling a given security. This gives the fund manager flexibility to sell lots that have the lowest tax bite.
- These funds will only sell their complete holdings of a specific security if the index itself removes the security, which is a good thing for investors, since such sales can result in large capital gains.
And because of the way they trade, ETFs may have an additional tax benefit.
When you sell shares of an ETF, you're selling to another buyer as opposed to the fund company. This means the fund itself usually isn't involved in the transaction and doesn't have to sell any securities, potentially triggering capital gains.
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Tax-managed stock funds
Some mutual funds are managed specifically to minimize the investors' tax burden, using strategies like:
- Avoiding dividend-paying stocks.
- Offsetting capital gains with losses.
- Holding stocks for an extended period to avoid short-term gains.
Tax-managed funds are usually more expensive than comparable funds that don't have that additional layer of tax management. So they'll probably make sense for you only if you're in a higher tax bracket.*
Municipal bonds & bond funds
Income from municipal bonds, which are issued by state, city, and local governments, is generally free from federal taxes.** These bonds are often called "tax-exempt bonds." Municipal bond income is also usually free from state tax in the state where the bond was issued.
Because they offer this special tax treatment, these bonds generally give you lower interest rates than comparable taxable bonds. So like tax-managed funds, they make the most sense for investors in higher tax brackets.
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How to lower your taxes
A type of fund that seeks to track the performance of a particular market index by buying and holding all or a representative sample of the securities in the index, in the same proportions as their weightings in the index.
A type of investment that pools shareholder money and invests it in a variety of securities. Each investor owns shares of the fund and can buy or sell these shares at any time. Mutual funds are typically more diversified, low-cost, and convenient than investing in individual securities, and they're professionally managed.
A type of investment with characteristics of both mutual funds and individual stocks. ETFs are professionally managed and typically diversified, like mutual funds, but they can be bought and sold at any point during the trading day using straightforward or sophisticated strategies.
An unmanaged group of securities whose overall performance is used as a benchmark. An index may be broad or focus on one sector or type of security.
An increase in the value of an investment over the initial purchase price. A capital gain is "unrealized" until the investment is sold, when it becomes a realized gain. Realized gains are taxable and they may be considered short-term (if the investment was owned one year or less) or long-term (if the investment was owned for more than one year).
The distribution of the interest or income produced by a fund's holdings to its shareholders, or a payment of cash or stock from a company's earnings to each stockholder.
Usually refers to common stock, which is an investment that represents part ownership in a corporation. Each share of stock is a proportional stake in the corporation's assets and profits.
The income on an investment, expressed as a percentage of the investment's value.
Shares acquired in one transaction. You can own multiple lots of an investment if you acquired shares of the same security at different times.
A bond represents a loan made to a corporation or government in exchange for regular interest payments. The bond issuer agrees to pay back the loan by a specific date. Bonds can be traded on the secondary market.