Roth IRAs

The Roth IRA is a new type of retirement account with significant advantages for most investors. Unlike a traditional IRA, the money you contribute to a Roth IRA is taxable at the time you invest it.
However, the income enjoyed by your Roth IRA account is not taxed, nor is the money in the account when you withdraw and spend it after retirement. This is a huge tax break, because your $2,000 annual contribution is likely to have grown into tens of thousands of dollars by the time you retire — all of which will be yours to use, tax-free. Generally speaking, the only people for whom a traditional IRA is probably a better deal than the Roth IRA are those who are less than ten years away from retirement. For them, the immediate deductibility of this year’s contribution may be worth more than the back-end deductibility of the Roth IRA.
Your broker, banker, or mutual fund company can help you with the calculations if you’re unsure which type of account is better for you.

Individual Retirement Accounts (IRAs)

Any American whose income is below a legally specified level can save up to $2,000 per year in an IRA account tax-free. This means that you pay no income taxes on the money you invest in your IRA, and the interest, dividends, and other income enjoyed by the money continues to be tax-free for as long as you let the investment grow. When you retire and begin withdrawing the IRA money, the funds are taxed as ordinary income at your applicable tax rate — which is likely to be lower than your current tax rate, because you no longer earn a salary.
Check current tax law to find out whether you’re eligible for an IRA account. The answer will depend on your income and on whether you’re covered by your employer’s pension plan. If you’re not covered by such a plan, you’re fully eligible for the IRA tax deduction; if you are covered, the income limits kick in.
Any mutual fund company, brokerage firm, bank, or other financial company can help you set up an IRA account. You can then fund it with whatever investment you choose, including your choice of mutual fund.
When investing in an IRA or any other tax-deferred retirement plan, don’t invest in a municipal bond fund or in any other fund type that specializes in low-tax or no-tax investing. Remember, such funds generally produce a lower rate of return than similar taxable funds, and because you are not paying any taxes on the income you enjoy from the fund, you have no reason to settle for that lower rate.

Tax-Deferred Retirement Accounts

If your primary investment goal is retirement, taxes need not be a major issue. Thanks to federal laws designed to encourage retirement savings, several special kinds of investment accounts are currently available that enable you to save on current taxes as you invest for retirement. Any mutual fund investment can enjoy major tax benefits if it is placed in one of these tax-deferred retirement accounts. Every smart investor who is putting away money for a comfortable old age owes it to himself or herself to open such an account. Your money grows much faster in a tax-deferred account than in an ordinary

Municipal bond funds

A municipal bond fund is another kind of tax-advantaged mutual fund. A municipal bond fund invests in bonds issued by state, county, city, and other local government agencies. Most income from these bonds is exempt from federal income taxes (although you must report the income on your federal income tax return). If you live in a state that levies a high state income tax, such as New York, California, or Massachusetts, you may want to consider a single-state fund, which invests in municipal bonds issued only in that state. Income from such a fund is exempt from state taxes as well as federal taxes, and may even be exempt from local taxes in a city (like New York) that levies a local income tax. Over 600 such single-state funds are currently available, covering some 30 states.
Despite the tax advantages of single-state funds, they’re not for every investor. Some single-state portfolios are relatively risky. Because the fund manager is restricted to buying bonds issued in one state only, he may be forced to invest in some counties or government agencies whose credit is shaky. If the agency defaults on its obligations — that is, if it fails to make timely payment of the interest due on its bonds — the value of the portfolio may suffer significantly. Study the prospectus of any municipal bond fund you are considering buying, and make sure you understand the degree of safety or risk involved with the bond investments held in the portfolio.
If safety is especially important to you, consider a municipal bond fund that invests only in insured bonds. These are bonds guaranteed by an independent agency that promises to make timely interest payments if the issuing agency runs into financial difficulties.
The prospectus for any fund you’re considering states whether the portfolio includes insured bonds. The safety does come at a cost; generally speaking, an insured bond fund has a return that is 0.1% to 0.4% lower per year than an uninsured bond fund. You have to decide whether this lower return is a reasonable trade-off for you.
Although interest and dividends from municipal bond funds are not taxable, capital gains (if any) generally are. Be careful to distinguish the different forms of income and treat them correctly on your tax return.

Tax-advantaged mutual funds

Tax-advantaged mutual funds are funds whose investment holdings are designed to minimize the investor’s tax liability. They may or may not be tax-managed, but their approach tends to be tax-efficient over time, resulting in overall lower tax payments by investors.
Index funds are the premier form of tax-advantaged investment. Index funds feature a passive style of investing, in which the fund manager buys and sells stocks only as needed to ensure that the fund continues to mirror the index on which it’s modeled. Because the manager of an index fund doesn’t do a lot of trading, relatively low amounts of capital gains are realized during any given year, minimizing the tax bite you must pay. Perhaps the most tax-efficient fund type available today is an index fund that is specifically managed to minimize capital gains distributions. This involves certain accounting practices that the fund manager must be careful to follow, including identifying for the Internal Revenue Service the bought and sold specific shares of a given company. By selling first all shares bought at a higher price and holding on to those bought at a lower price, a fund manager can reduce taxable distributions to investors significantly. If you’re interested in a tax-advantaged mutual fund, contact Charles Schwab and Vanguard. These two mutual fund companies are among those that offer tax-efficient index funds specifically designed to keep capital gains taxes as low as possible.

Understanding Tax-Managed Funds

Tax-managed funds are those in which tax effects are incorporated in the fund manager’s decision-making process. The manager of such a fund is guided in her buying and selling decisions, in part, by considerations of how to avoid incurring excessive capital gains taxes in any given year. For example, suppose that Jane Goodbucks is the manager of Fund T, a tax-managed fund. Jane may be contemplating selling the fund’s shares of Microsoft, the giant software company, because she and her research staff expect the value of Microsoft stock to increase at a rate of just 10% a year during the next several years — a little lower than Jane would like. Jane is considering replacing her Microsoft stock with shares of Amazon.com, the online retailer, which she expects to grow at 11% a year.
If Jane ignores tax effects, she is likely to sell the Microsoft stock and buy Amazon.com. But because Fund T is a tax managed fund, Jane first considers the cost her shareholders can expect to incur for capital gains. The taxes due will depend on the amount of the gains realized, which will depend, in turn, on how long Fund T held Microsoft and how far the stock increased during that time. Based on these considerations, Jane may or may not decide to sell Microsoft. Due to the effect of taxes, trading Microsoft for Amazon.com may result in lower returns for investors, so holding the Microsoft shares may be the better choice. You can find out whether a fund is tax-managed by reading the fund prospectus. Unless the prospectus states otherwise, assume the fund is not tax-managed. If tax considerations are important to you, consider focusing your fund choices specifically on those that are managed with tax effects in mind.

Tax on mutual funds capital gains

Capital gains — profits from an increase in the value of the securities held by the mutual fund — may be either realized or unrealized. Their tax status differs accordingly, with only realized profits being eligible for taxation. Here’s how it works.
Capital gains are realized when the fund manager sells stocks (or, less commonly, bonds) at a price greater than their purchase price. When stocks held by the fund increase in price but are still held, the capital gains are unrealized.
Capital gains are taxed only when they are realized. For example, suppose Sharon owns shares of Fund M, whose net asset value increases by 10% during the course of a year due to a 10% increase of the value of the stocks owned by the fund. If the fund manager sold no securities during the year, the investor would receive no realized gains in the current year — therefore, no taxes due on capital gains. However, suppose Sharon decides to sell her shares of Fund M. (Maybe she needs to cash in her investment in order to make a down payment on a new house.) When she does so, she is realizing (literally “making real”) the profits earned by the fund due to the increase in the value of the stocks it owns. These profits are now capital gains on which Sharon is obligated to pay taxes.
If you plan to sell your mutual fund shares, consider the tax implications of your timing. If the value of your shares has grown significantly, so that you can expect a large tax payment, consider whether you want to accelerate the transaction (making the sale by December of the current year) or to delay it (pushing it back into next January), depending on which year your income may be greater. Realizing your profits and paying taxes on them may be less painful during a year when your income is smaller and your tax rate is therefore lower.
Current tax law also distinguishes between short-term and long-term capital gains. Short-term capital gains are profits from sales of securities held by the fund for 18 months or less. The government taxes these gains at the same rate as ordinary income, just like dividends. In fact, you will actually find short-term capital gains listed in the “dividend income” box on your Form 1099-DIV because the tax rate is the same.
Long-term capital gains, on the other hand, are profits from the sale of securities held by the fund for longer than 18 months. These profits are taxed at a more favorable rate. If you are in the 15% tax bracket, the government taxes any long-term capital gains you enjoy taxed at just 10%; if you are in the 28% bracket or higher, your long-term capital gains are taxed at 20%.
As you can see by its design, federal tax law encourages investors — including fund managers — to hold on to securities for a longer time. Taxing long-term capital gains less heavily than short-term capital gains is another reason why a mutual fund with a lower turnover rate may be more beneficial for the investor than a fund that buys and sells stocks rapidly.

Tax on mutual funds dividends

Unless you invest your money in a tax-deferred retirement account (as explained later in this chapter), dividends you receive in the form of a distribution are generally treated as taxable income. Currently, the government taxes dividends at the ordinary federal income tax rate of 15% to 39.6%, depending on your overall taxable income. You generally have a choice (selected when you open your mutual fund account) of receiving dividend distributions in the form of a payment by check or reinvesting them in the purchase of additional shares of the fund. Don’t fall for the myth that if you reinvest the dividends you receive, the dividends are not taxable.
Unfortunately, that wishful thinking is not true. Although you never actually see the dividends in the form of cash, the dividends reinvested on your behalf during the year appear on your 1099-DIV form, and the IRS expects payment of all taxes due on these dividends.
If you want to avoid paying taxes on dividend income, you can opt to invest in a growth fund or a small cap fund. Such funds generally pay lower dividends than large cap funds or income funds, because they invest in small companies that use their profits to finance business expansion rather than paying dividends to investors. As a result, you’re likely to receive lower dividends while enjoying greater profits in the form of net asset value growth.
However, the positive tax effect of lower dividends may be spoiled if the fund’s rate of turnover is unusually high. If the fund manager buys and sells stocks frequently, the fund is likely to experience greater than average capital gains, on which the individual investor must also pay taxes. So, if you choose a fund partly to avoid heavy tax payments, make sure to check its turnover rate before investing. You can also delay or avoid some tax liabilities for dividend income by choosing a tax exempt municipal bond fund or by putting your mutual fund investments in a tax-deferred account, such as an IRA or 401(k).

Tax Consequences of Mutual Fund Profits

You can profit in three ways when you own a mutual fund: through any increase in the net asset value (NAV) of the fund shares; through dividends; and through capital gains. Each of these kinds of profit has a potential impact on the taxes you have to pay. For most investors, tax considerations are not worthy of top ranking on the list of concerns that may affect decisions about buying or selling a mutual fund. Most people are wise to buy and sell mutual funds based on their changing financial goals and their perceptions of the investment markets and the overall economy rather than worrying too much about the relatively small tax consequences of their decisions. However, if you’re in a higher tax bracket (31% to 39.6%), you may want to take the tax implications of your mutual fund investment decisions more seriously. Here are the things you need to know.
At least annually, a mutual fund must distribute to investors the dividends and capital gains that the fund’s portfolio has generated over the course of the year. As Dividends are a portion of the profits generated by a company and shared with those who own stock in the company, and capital gains represent the difference between the price at which you purchased a security and the higher price at which you sold it — the profits.
Bond funds usually distribute the income received from their investments in the form of a monthly dividend. Stock (equity) funds and balanced funds, which hold both stocks and bonds, may distribute dividends quarterly, annually, or semiannually. Capital gains are distributed once a year. Around the end of the calendar year, the mutual fund company sends you a 1099-DIV form detailing the taxable distributions that you received during the year. You use this information when preparing your income tax return for submission by the following April 15.

Dollar Cost Averaging

Dollar cost averaging is a technique whereby an investor puts a fixed amount of money into the same investment vehicle at regular intervals. For example, if Ian invests $500 a month into a mutual fund every month, he is dollar cost averaging. Dollar cost averaging offers a number of benefits. For many investors, the habit of investing regularly is a difficult one to develop and maintain. Setting aside the same amount of money from each paycheck is a good way to develop this discipline. Many mutual fund companies can arrange automatic deductions from your checking or savings account which make it even easier to invest regularly. You’ll soon find that you hardly miss the money which is going to build a steadily increasing investment nest egg.
Dollar cost averaging also increases the rate of return on your investment dollar. Here’s how it works. Suppose Ian invests his $500 a month into a mutual fund whose net asset value per share varies between $20 and $40. During months when the NAV is lower, Ian’s $500 will enable him to buy more shares; when the NAV is higher, he’ll buy fewer shares. The beauty of dollar cost averaging is that, over time, by investing the same amount each month, Ian will buy more shares at a relatively lower price. Therefore, his average price per share will be lower, meaning that his investment profits will be greater.
See Table 8-2 for an illustration of how this works. Over the year shown, with the NAV of Ian’s Fund F varying between $20 and $40 per share, the average NAV is $30.08 per share (calculated simply by adding the average monthly NAV — $20 in January, $24 in February, and so on — and then dividing the sum by 12). But Ian has been able to buy a total of more than 208 shares for $6,000. Thus, the average per share price Ian has actually paid is just $28.83 — more than a dollar less than the average NAV for the period.
Dollar cost averaging always works this way: By buying more shares when the price goes down, you reduce your per-share purchase price and so stretch your investing dollar. Dollar cost averaging enables the investor to regard a decline in NAV not as a loss of value but rather an opportunity to buy more fund shares at a discount price. I strongly recommend it to all new investors — and to experienced ones who’ve never enjoyed its benefits.