Tax Strategies: Tax Tips to Know

No one should pay more income tax than the rules require. But if you don't know the regulations, it may be easy to make mistakes that could be costly. Learn how the following techniques may help you as you examine what tax strategies make sense for your investments.

Understand How Cost Basis Affects Your Taxes

Cost basis is the dollar amount you paid to acquire your shares over time through investment and reinvestment. When you sell shares of a mutual fund held in a taxable account (non-money market), you owe tax on any gains—the difference between your cost basis (what you’ve paid) and what you sold it for. But determining that amount can be tricky, especially if you've invested money into a fund at different times or reinvested dividends.

Starting in 2012, IRS regulations required financial services companies to track and report cost basis for taxable accounts. There are several methods for you to choose from. When you invest in mutual funds, the fund provider will ask you to select a cost basis method. Common options include average cost and first in, first out. Learn more about your choice of calculation methods.

Review Year-End Distribution Dates

Mutual funds distribute to shareholders their portion of proceeds from the sale of the fund’s underlying assets during the year. This distribution often occurs in December. The price per share of the fund is adjusted down to make up for the distribution, so the value of the share price doesn’t increase based on the payment. If you invest in a fund close to the distribution date, you could have to pay tax on the gains. Some investors delay purchasing shares in a fund until after this date, which is called the ex-dividend date, to help avoid paying these taxes. This alone shouldn’t dictate how you invest but is one consideration. Being aware of the estimated distribution amounts for your funds, which typically come out in late October for that year, can also help you estimate your tax bill for your upcoming tax filing. And if it’s close to the end of the year, there are other year-end tax tips to consider.

Consider the Tax Implications of Exchanging

Mutual fund companies often let you move shares from one fund to another (called an exchange). In the eyes of the IRS, an exchange is seen as selling the shares of the first fund and buying shares of the second. That means the sale of the first fund is a taxable event unless the funds are in an IRA, retirement plan or other tax-deferred account.

Consider Tax-Efficient Funds

Mutual funds you hold outside of a tax-deferred account will be subject to taxation. Tax-deferred includes accounts such as 401(k)s or IRAs.

If you plan to invest in a taxable mutual fund account, you may want to talk to an advisor about which funds may help you achieve your specific goal(s). Your needs may be to grow your investments, get income from them, lower volatility risk for retirement, mitigate taxes or inflation, etc.

If you’re thinking about taxes and income in retirement, you could explore municipal bond funds, which pay interest that is free of federal taxes and often some state and local taxes as well.

Offset Capital Gains With Capital Losses

Another tax tip is to turn investment losses into something positive on your tax bill, often referred to as tax-loss harvesting. You may be able to use capital losses from one mutual fund investment to offset capital gains from another, dollar for dollar.

If you don’t have investment gains to post the loss against, you can take the loss against your ordinary income. Note you can use losses to offset up to $3,000 in gains per year, with any remaining losses eligible to be carried forward to future years. Talk to your tax advisor or visit irs.gov for more information.

Though taxes can impact your investment returns, they should never be the only, or even the most important, consideration when investing. You should look for funds that align with your long-term investment strategy and goals.

Get a snapshot of tax rates, estate exemptions, IRA limits and more.