As you build a portfolio to pursue your financial goals, it's important to consider the taxes on your investments.

You already may be making full use of tax-advantaged accounts such as 401(k) plans and IRAs for retirement, or state-sponsored 529 plans for a college education. If you want to use mutual funds for investments in taxable accounts, the types of funds you choose and the strategies you follow can help you anticipate and manage your tax obligation.

Choosing a tax-wise mutual fund

Generally, a mutual fund may emphasize tax efficiency by using techniques such as:

  • Owning securities that pay few dividends, reducing taxable additions to your income;
  • Offsetting gains on one security with losses from another;
  • Limiting the buying and selling of securities in the fund's portfolio.

A fund that actively buys and sells securities usually will have more distributions of capital gains than one that holds securities for longer periods. You generally must pay taxes on these distributions. The turnover rate - expressed as a percentage - gives you an idea of how often a fund makes changes to the securities in its portfolio and can be one indicator of your exposure to taxes.


Planning for taxable accounts

If you invest through a taxable account, you'll have to deal with taxes on a couple of fronts. If you sell, or redeem, mutual fund shares from your account, any gain on your investments will be subject to taxes. The tax rate will depend on your tax bracket and the length of time you owned those shares.

The same holds true if you exchange shares between mutual funds, since an exchange involves selling shares of one fund and buying shares of another. If you sell shares at a gain, you'll have to pay taxes on that gain.

In addition, a mutual fund is required to distribute each year any income from its investments as well as the capital gains realized from investments sold during the year. Distributions are paid to you as a shareholder according to the number of fund shares you own, regardless of how long you have owned those shares. You'll owe taxes on both dividend income and capital gain distributions. The tax rate you will pay depends on your circumstances:

  • You are taxed at the long-term capital gains tax rate on qualified dividends distributed by your fund each year. As a general rule, qualified dividends are paid by domestic and foreign stocks in which the fund invests that meet certain holding period requirements.
  • You are taxed at your ordinary income tax rate on interest income.
  • You are taxed at your ordinary income tax rate on short-term capital gain distributions, or the sale of fund shares you owned for 12 months or less.
  • You are taxed at your long-term capital gain tax rate on long-term capital gain distributions, or the sale of fund shares you owned for more than 12 months.

The maximum tax rate on long-term capital gains is 15%. So if you're in a higher tax bracket, you may benefit by looking for a fund that holds the securities in its portfolio long enough for any distributions to qualify as long-term capital gains or pays qualified dividends.


Pursuing your goals

As you review your options, choose the best investments to achieve your goals - not necessarily those that offer the greatest tax benefits.

For example, the main objective for retirement investments usually is long-term growth. A municipal bond fund, which generates income that usually is exempt from federal income tax, may offer tax advantages but may not provide the long-term growth you seek for your retirement nest egg.

You also should choose investments consistent with your risk tolerance and investment strategy. Such investments are more likely to help you meet your financial goals, even with the cost of taxes. Taxes should never be the only - or even the most important - issue when investing for long-term goals.


IRS Circular 230 Disclosure: American Century Companies, Inc. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with American Century Companies, Inc. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties.

This information is for educational purposes only and not intended as tax advice. Please consult your tax advisor for more detailed information or for advice regarding your individual situation.