Strategies for Reducing Tax Liabilities with Mutual Funds
One can easily be fortunate or unfortunate in the world of investments. The key to prospering is to understand the consequences of actions taken in order to remain in the game. Winners only keep winning if they are consistent in their approach.
Mutual funds are attractive as an investment tool because they allow the investor to combine the power of many incomes in securing a better than average return on an investment. A mutual fund is a pool of money that is invested in many different stocks, bonds or other investments (Financial matters..., 1995, PG). The skills of a fund manager are used in investing and selling in high return, low risk shares that can yield an average annual total return as high as 18.1 percent (Siedell, 1995, 55).
The difficulty with mutual funds lies in tax considerations. Federal regulations stipulate that a mutual fund must pay out to shareholders virtually all of the income and capital gains it realizes each year. Capital gains are "realized" when a fund sells a security for a profit. That payout is then taxable to shareholders, dividends and short term capital gains at the shareholder's tax rate, and long term capital gains at 28 percent (Siedell, 1995, 55). In order to stay in the game and avoid paying the tax liabilities that ensue from the successful use of mutual funds, several strategies have been evolved.
First there must be a recognition of how tax liabilities are incurred from mutual funds. Mutual funds, unlike some other investments, generate taxable income while they are owned, and when they are sold (Financial Matters..., 1995, PG). Essentially, the risk of tax liability happens in one of three ways. The first way in which taxable income is generated is when an investment in a mutual fund is sold, this may produce capital gains. The proceeds must be distributed to the shareholders of the fund. These capital gai...