When planning mutual fund investments, individual investors often overlook tax considerations that can have a negative impact. But you’ve got to handle these valuable assets with care. Steering clear of year-end investments, opting to invest in tax-efficient funds, and understanding how reinvested distributions can affect you can protect you from certain tax liabilities.

End-of-Year Considerations that Can Help You Avoid Certain Tax Liabilities on Mutual Funds

Avoid Year-end Mutual Fund Investments

Typically, mutual funds distribute accumulated dividends and capital gains toward the end of the year. However, you don’t want to fall prey to the common misconception that investing in a fund just before a distribution date is like getting “free money.”

Although you’ll receive a year’s worth of income right after you invest, the value of your shares will immediately drop by the same amount, so you will actually be no better off. In addition, the distribution will have tax liabilities as if you had owned your shares all year.

You can get a general idea of when a particular fund anticipates making a distribution by checking its website, periodically. Also make a note of the “record date” — investors who own fund shares on that date will participate in the distribution.

Invest in Tax-efficient Funds

Actively managed funds tend to be less tax efficient. They buy and sell securities more frequently, generating a greater amount of capital gain, much of it short-term gain taxable at ordinary income rates rather than at the lower, long-term capital gains rates.

Consider investing in tax-efficient funds instead. For example, index funds generally have lower turnover rates. “Passively managed” funds (sometimes described as “tax managed” funds) are designed to minimize taxable distributions, as well.

Another option is Exchange-traded Funds (ETFs). Unlike mutual funds, which generally redeem shares by selling securities, ETFs are often able to redeem securities “in kind” — that is, to swap them for other securities. This limits an ETF’s recognition of capital gains, making it more tax efficient.

This isn’t to say that tax-inefficient funds don’t have a place in your portfolio. In some cases, actively managed funds may offer benefits that outweigh their tax costs – such as above-market returns.

Understand Reinvested Distributions

Many investors elect to have their distributions automatically reinvested in their funds. Be aware that those distributions are taxable regardless of whether they’re reinvested or paid out in cash.

Reinvested distributions increase your tax basis in a fund, so you’ll want to be sure to track your basis carefully. If you fail to account for these distributions, you’ll end up paying tax on them twice — once when they’re paid and again when you sell your shares in the fund.

Fortunately, under current rules, mutual fund companies are required to track your basis for you. You still may need to track your basis in funds you owned before 2012 when this requirement took effect, or if you purchased units in the fund outside of the current broker holding your units.

Directing Tax-inefficient Funds into Nontaxable Accounts

If you invest in actively managed or other tax-inefficient funds, ideally you should put these holdings into nontaxable accounts, such as a traditional IRA or 401(k). Because earnings in these accounts are tax-deferred, distributions from funds they hold won’t have any tax consequences until you withdraw them. If the funds are held in a Roth account, those distributions will escape taxation altogether.

Tax considerations should never be the primary driver of your investment decisions, yet it’s important to do your due diligence on the potential tax consequences of funds you’re considering — particularly for your taxable accounts.

If you have questions about mutual fund investments and their tax liabilities, please contact your Untracht Early advisor.