How to Lower Your Mutual Fund Taxes

1. Before you buy a fund, consider the tax implications. Every time the fund manager buys or sells stock within the fund, it creates a taxable event. The rate at which a fund manager buys and sells investments in the fund's portfolio is called the "portfolio turnover." The lower the turnover ratio, the lower your taxes. If taxes are a serious concern to you, stay away from funds with high turnover ratios (the closer to 100% turnover, the higher your taxes).
   
   Certain types of funds tend to have a higher turnover than others. Aggressive-growth funds generally have a higher turnover than growth and income funds, for example.
2. Buy a fund AFTER it has paid out its dividend. Let's say a fund is going to pay its dividend on December 1. You invest $2,500 on November 30–which buys you 100 shares at $25 apiece. On December 1, you receive a $1.20 dividend per share. The share price drops to $23.80 to reflect the dividend payout, and you owe taxes on $1.20.
   
   Your friend, Bob, invests $2,500 in the fund on December 2 (after the dividend was paid) and gets 105 shares for $23.50. The difference: Bob doesn't owe taxes on the $1.20 dividend and you do!
   
3. Remember that switching money between mutual funds—even within the same fund family—is a taxable event. You may think of it as swapping funds, but you are actually selling shares of one fund to buy another. An exchange of shares from any mutual fund to another is considered a "sale" and subsequent purchase for tax purposes.
4. Avoid the dreaded "double dividend" tax trap. If you reinvest your dividends, you could get caught in the most common mutual fund tax trap we know of–paying taxes on those dividends twice.
   
   Here is an example: Say you buy 200 shares of Widget fund for $20 a share (a $4,000 investment). The fund pays you $460 in dividends, which you automatically reinvest for 20 more shares. The fund hits $24, so you decide to sell.Here's where most people make their mistake.
   
   Your cost basis is not $20 a share. The shares you bought with the $460 had a cost basis of $23, not $20. So, you're selling 200 shares at $4 taxable profit (the current $24 price minus the $20 cost basis) and 20 shares at a $1 taxable profit ($24-$23). If you had lumped those 20 shares in at the same cost basis as your original 200, you would owe taxes on an extra $60!
5. Keep very thorough records. Besides keeping every darn piece of paper your mutual fund sends you, we suggest starting a logbook to track your transactions. Use any old spiral notebook to write down every purchase, sale, transfer, dividend, and distribution (and note whether you received it or automatically reinvested it). This log will become your best friend come tax time.