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  • Michael DiBartolomeo

Tax-Managed Mutual Funds

Investing is an excellent method of potentially generating an income. However, the earnings gained from these investments are usually subject to income tax, much like any other payment form.

Mutual funds are an exceptionally popular investment option. Despite this, mutual funds hold the ability to create a significant tax burden in some instances. It's important that a person ensures their mutual fund is tax-efficiently managed because singular investors don't have any control over a mutual fund's investment activity.

What are tax-managed mutual funds

What Are Tax-Managed Mutual Funds?

Tax-managed funds are used to limit the tax burdens faced by shareholders. These tax-managed mutual funds use a variety of strategies as a means of minimizing taxes and provide a return to their investment portfolio.

One strategy that's used is avoiding dividend-paying stocks when investing. These mechanisms included in tax-managed mutual funds also strive to limit any capital gains. This is done by holding the securities review from the mutual funds for a long period or selling losing stocks. This reduces the taxable gains received from mutual funds.

How Can Tax-Managed Mutual Funds Lower a Tax Bill?

When investing tax-efficiently, an investor holds the ability to reduce their tax bill. This is largely due to the elements incorporated, which aid in the tax being better managed. Tax brackets play a role in avoiding such tax and ensuring that the investment is effectively managed. Thus, they are able to keep more of their investment returns than their investing activities earn them. An effective way to gain this is to make use of mutual funds.

Effectively using tax-managed funds only apply if the investor is making use of a brokerage account. An exception to this is if a person invests in mutual bonds, funds, and stocks that are not incorporated inside a retirement account.

This is largely because investments in a retirement account such as 401(k) or IRA are only subject to tax once a person begins withdrawing from the account. Thus, a 401 (k) or IRA are excellent retirement investment options for investors who wish to accumulate wealth.

How Do Tax-Managed Funds Provide Control To Investors When Taxes Are Incurred?

Tax-managed funds provide control to investors when they incur taxes on gains. The reason for this is because these investors receive most of their capital gains as unrealized gains. These unrealized gains and returns aren't taxable until the investor sells their shares on the particular funds.

What Are the Two Types of Capital Gains?

There are two different types of capital gains and return. Both of these have different characteristics. These are short term and long-term capital gains and returns. The different features of each type of capital gain are as follows:

Capital Gains Upon the Sale of Shares of the Particular Fund

When a person sells shares of a mutual fund, they are going to realize either a short-term or long-term capital gain if they sell these mutual funds for more than they paid for these investments.

Investors who fit into the 10 percent or 15 percent tax bracket gain a zero percent capital gain tax rate to a particular amount of realized gains and returns. Many investors gain the opportunity to sell the shares of their funds throughout a specific year where their tax rate is low. This gives them the opportunity to pay no taxes on their gains and returns.

Embedded Gains That Are Distributed Annually

Inside a mutual fund, a gain must be passed along to the buyer as a shareholder of the fund when the fund that has a gain sells as bonds or other investments. The investor is still going to receive a 1099 form even if they have all of the dividends, capital gains, and returns reinvested. Thus, the investor is going to have to report the gain on their tax return and pay the amount of tax that's applicable.

Most of these investments' data distribute the types of internal capital gains at the end of the financial year. Meaning, with the majority of mutual funds, the investor is going to have some amount of capital gains to report every year even if they don't sell any shares of the fund.

What Are the Disadvantages of Embedded Gains?

The name for an embedded capital gain gets its name because the owner of an embedded capital gain, even if only owned for a short period, may end up receiving a capital gain distribution and paying tax. Why does this occur? The fund may have been bought a while back, even before the current owner of the fund purchased it. The owner is going to have to participate in their proportional share of the capital gain of the specific stock even though the owner only had possession of the fund and its financial data for a short period.

How Are the Disadvantages of Embedded Gains Combated?

A mutual fund that's tax-managed in such a way to aid in minimizing capital gain distributions. The interior of the fund is equipped with features that work to harvest losses that offset the gains.

The end result of this is that the owner holds the ability to see their gains happen from watching the price of the fund increase (Capital Gains Upon the Sale of Shares of the Particular Fund), rather than the alternative of having a more significant amount of annual capital gain distributions written into the 1099 form. Due to the owner having control when they sell the shares, they have more control over the tax year that these gains occur and are reported.

Funds that are equipped with tax-managed features also hold the ability to reduce additional types of taxable distributions. These additional distributions include dividend income and interest. An example instance where this would apply is a tax-managed balanced fund that owns bonds and other investment types often owns municipal bonds. These generate interest that's free from federal income taxes.

Tax-managed funds place the control on their hands when the owners of these funds realize their capital gains. This is a particularly important element when dealing with retirement. Owners of these tax-managed funds don't want a surprise tax bill, or a sudden increase in their taxable income as this can make more of their Social Security taxable.

Moreover, as previously mentioned, there is a zero percent tax rate on any long-term capital gains if owners of these tax-managed funds are in the 10 percent or 15 percent tax brackets. Owners of these tax-managed funds may have control when the gains occur as they hold the ability to decide when they wish to sell the shares of the fund. Thus, they can choose to sell the shares when in a tax year where the gain is not going to be taxed. When used properly, these tax-managed funds may be used as a method to realize tax-free income in retirement.

What Are the Differences in Fund Tax Rates?

The tax rates applicable to capital gains are always lower than the corresponding tax rates associated with income. However, the difference between these tax rates may vary. Persons who make $78,750 or less aren't required to pay tax on their capital gains. In contrast, individuals who make as much as $434,550 are required to pay tax amounting to 15 percent of their capital gains. In addition to this, persons who make more than $434,550 have to pay a tax rate of 20 percent on their capital gains.

When looking at this practically, a person who makes $80,000 and receives $1,000 in investment income from selling stock is subject to pay 15 percent in tax rates of this investment income, which amounts to $150. However, this only applies if this particular person has had ownership of this investment for more than one year. On the other hand, the person is going to have to pay $280 in taxes if this investment revenue is classified as a short-term gain.

An important element to understanding the tax-efficiency associated with a fund is that the taxing rate applying capital gains is always going to work out to be more efficiently tax-managed than when a mutual fund is taxed at an ordinary income tax rate.

Tax-efficient investing

What Are the Tax-Efficient Factors?

There are many factors that play a role in a fund being efficiently tax-managed. Here are some of the main contributing factors:

Asset Turnover

One of the most powerful methods of creating a more tax-efficient mutual fund is by reducing this fund's turnover ratio. The turnover ratio of any kind refers to the frequency that the fund sells and buys securities. A mutual fund that executes a large quality of trades throughout a given year is known to have a high asset turnover.

The end result of a high asset turnover is the owner of this fund gains more capital gains, which are short-term gains. Thus, these are usually taxed at the tax rate for ordinary revenue.

The mutual fund that successfully implements a buy-and-hold strategy, as well as invests in long-term bonds and growth shocks, are generally more tax-efficient. This is primarily because these funds generate revenue that's taxable at a lower capital gain tax rate.

Owners of a fund that distributes capital gains are going to trigger the issue of a Form 1099-DIV, which outlines the amount of the distribution applicable to the long-term gains of the fund.

Moreover, a very active mutual fund is also known to have a higher expense ratio, or a larger amount of money the fund charges every year in order to maintain the fund itself, as well as cover the operating and administrative costs. Due to this occurring, there isn't a large impact on the owner's yearly taxes. Thus, it can be a significant drain on the investor's finances.


An investor is likely to receive one or more dividend distributions each year. This only occurs if their mutual fund is equipped with investments in dividend-paying bonds that implement paying periodic interest that's commonly called coupon payments. There's no doubt that this is a convenient source of regular revenue. However, the benefits of such a quality may be outweighed by an increase in the investor's tax bill.

The majority of dividends are seen as ordinary revenue. The taxes associated with this are applicable to normal rates. Due to this, a mutual fund that doesn't pay dividends is naturally going to be more tax-efficient. Investing in funds that don't provide coupon-bearing stocks or dividend-bearing stocks is a tax-efficient and incredibly clever choice for investors who have investment goals geared to growing wealth instead of generating regular revenue.

A Middle Ground for Dividend-Related Tax-Efficiency

Although investing in funds equipped with dividend-bearing stocks or coupon-bearing stocks is more tax-efficient, some investors find that dividend distributions are one of the primary benefits of owning a fund. However, these investors still may want to reduce their overall tax burden as much as possible.

There is a type of dividend that fits with these investors’ goals. This type of dividend is called a qualified dividend and is subject to a lower rate of capital gains tax.

This dividend needs to meet a certain criteria, such as a holding period requirement, in order to be considered qualified. A qualified dividend fund may only be paid by the US or eligible foreign corporation, along with being purchased before the ex-dividend date.

The ex-dividend date is known as the date after the subsequent share applicable for the upcoming dividend. In order for this to be eligible, the stock needs to have been held for at least 60 days within a period of 121 days that begins 60 days before this specific date.

Even if an investor purchases shares in a mutual fund tomorrow and receives dividend distribution within the following week, that specific dividend is considered as 'qualified' in the fund only when it meets the above-mentioned holding requirements.

Tax-Free Funds

Another method of optimizing a mutual fund and make it more tax-efficient is to purchase funds that include investments in municipal and government bonds that's generated interest that isn't subject to federal revenue tax. Some funds only invest in these security forms are also known as tax-free funds.

Funds that aren't considered tax-free but include some of these securities types are seen as being tax-efficient than funds that are part of corporate bonds, as these bonds generate taxable interest that's subject to tax with an ordinary rate.

Fund vs. ETF Tax Efficiency

Tax considerations for exchange-traded funds (ETF) and mutually-accepted funds are considered to be quite similar. However, there are some noticeable differences between funds and ETFs. One important element to remember is that there are a few exemptions to taxations. These are predominately municipal and treasury securities. Thus, funds and ETFs, in regards to these different securities, have their own tax-exempt characteristics. Therefore, the ETF's tax cost ratio and the tax cost ratio of the fund are likely to fluctuate. This is because the tax cost ratio is highly dependent on the difference in tax-efficiency of the tax-managed fund or the tax-managed ETF.

The Bottom Line

Tax-efficiency and the management of a fund may play a significant role in the tax portfolio and impact the accumulation of wealth on the particular investment. The performance of a fund and the tax associated with the fund is highly dependent on the financial strategies implemented into the overall management of the fund according to the current market conditions.

However, tax efficiency doesn't just mean the management of a particular fund. Some funds and stocks are naturally more tax-efficient than others. Thus, choosing the one that best fits the individual's investment goals is going to be different for everyone. Nonetheless, selecting the correct type in line with these investment goals can help make the tax-managed funds more efficient as the measures placed on these stocks can be configured to the exact needs of the owner. This is largely due to the features incorporated into the management of these funds is going to provide the tax-efficiency.

Elements such as dividend, asset turnover, and types of funds/ETFs all need to be considered when purchasing these investments. Not to mention, the length of time the shares have been hold in relation to the qualified dividend rules, places a significant role in the efficiency of these tax-managed funds. Thus, taking the time to understand all of these features aids in creating strategies that help the owner gain their desired investment goals.

Contact experienced Pittsburgh financial advisors for more information regarding tax-managed mutual funds, Alpha Mutual Funds, or to learn how to stop student loan wage garnishment.


Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. The content is developed from sources believed to be providing accurate information.

This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.

Investing in mutual funds involves risk, including possible loss of principle. Fund value will fluctuate with market conditions and it may not achieve its investment objective.

No investment strategy assures a profit or protects against loss.

The prices of small and mid-cap stocks are generally more volatile than large cap stocks.

International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investors yield may differ from the advertised yield.

Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate or return and fixed principal value.

Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax free but other state and local taxes may apply. If sold prior to maturity, capital gains tax could apply.

ETFs trade like stocks, are subject to investment risk, fluctuate in market value, and may trade at prices above or below the ETF’s net asset value (NAV). Upon redemption, the value of fund shares may be worth more or less than their original cost. ETFs carry additional risks such as not being diversified, possible trading halts, and index tracking errors.

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