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.
You use cost basis to determine if you have a capital gain or capital loss at the time you sell your shares. You must report all capital gains and losses to the IRS for tax purposes.
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.
You will be sent tax documents for the exchange from taxable accounts. Be sure to keep them for when you file your taxes. Get specifics on when to expect each tax form.
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 a mutual fund posted a loss of $2,000, that loss can offset $2,000 worth of gains you received from another fund.
This can get complicated, so it’s good to discuss with a tax professional.
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.
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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 is not intended as tax advice. Please consult your tax advisor for more detailed information or for advice regarding your individual situation.
IRA investment earnings are not taxed. Depending on the type of IRA and certain other factors, these earnings, as well as the original contributions, may be taxed at your ordinary income tax rate upon withdrawal. A 10% penalty may be imposed for early withdrawal before age 59½.
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
Municipal Funds:
Investment income may be subject to certain state and local taxes and, depending on your tax status, the federal alternative minimum tax (AMT). Capital gains are not exempt from state and federal income tax.
Municipal Securities investing is more sensitive to events that affect municipal markets, including legislative or political changes and the financial condition of the issuers of municipal securities. The fund may have a higher level of risk than funds that invest in a larger universe of securities. Additionally, the novel coronavirus (COVID-19) pandemic has significantly stressed the financial resources of many municipal issuers, which may impair a municipal issuer's ability to meet its financial obligations when due and could adversely impact the value of its bonds, which could negatively impact the performance of the fund.