Although taxes can chew through your mutual fund returns when you invest in a taxable account, the new tax law of 2003 can trim your tax bill.
The 2003 tax law is Washington’s gift to the long-term investor, offering substantial cuts in the tax rates on both capital gains and dividends. For investors using taxable accounts, buying and holding makes more sense than ever before. Because distributions of capital gains and dividends are taxable in these accounts, you must pay taxes on all of your distributions, whether you receive them in cash or reinvest them in fund shares. Paying taxes on distributions can cost you 2 to 3 percentage points of return each year. To make matters worse, when you reinvest mutual fund distributions, you must come up with cash from somewhere else to pay the taxes on those distributions on April 15. However, if you buy shares in tax-efficient funds to begin with, and then choose the shares you sell wisely, you can minimize your pain at tax time.
Uncle Sam is watching you and your fund company, and come April 15 he wants his cut. As a fund investor, you should evaluate the tax ramifications of the following mutual fund actions:
Selling shares of a fund that has increased in value.
Receiving interest from bond, money market, and REIT funds, distributed monthly to fund investors and taxed as ordinary income.
Receiving capital gains from any fund, including municipal bond funds.
Writing checks from any type of fund account ...