6 common questions about mutual funds and your taxes

When you’re researching mutual funds for your portfolio, it’s important to look at several factors, including the fund’s investment objective, track record, and risk level. But what about taxes? How much should they impact your decision?

Let’s look at six common questions that investors ask when thinking about mutual funds and taxes.

It depends on what type of account you have. Mutual funds held in a tax-advantaged account: retirement, college savings, or a health savings account (HSA), typically grow tax free, and you won’t pay taxes until you make withdrawals from those accounts.

For tax-exempt mutual funds like government or municipal bonds, you may not have to pay federal or state taxes because the interest generated by these bonds generally is not subject to income tax.

For mutual funds held in traditional brokerage accounts, it’s common to owe capital gains taxes if or when you sell your mutual fund shares and there is a realized gain.

If your mutual fund invests in dividend-paying stocks, you may owe taxes on those dividends as well.

In a given year, you could also owe taxes on your mutual fund (even if you haven’t sold any shares), if the fund manager causes the fund to realize gains by selling some of the fund’s holdings.

Capital gains distributions for a given tax year typically occur in November or December, but you won’t owe taxes on those gains (or any others realized throughout the year).

No. Short-term capital gains are generally taxed at higher rates than long-term capital gains. Some mutual funds can use long-term investment strategies to minimize the impact of short-term capital gains on the fund’s shareholders, compared to other funds that trade more frequently.

Not necessarily. The tax efficiency of a fund really depends on how well the managers strategically offset capital gains by selling securities with unrealized capital losses. This is called tax-loss harvesting.

No. Many investment professionals indicate that while income taxes should be considered in investing, they shouldn’t be the driving factor. Ideally, investors should focus on after-tax results. If an actively managed mutual fund has better results, the amount investors keep after taxes may still be greater than with an index fund.

There are several ways to reduce the impact of capital gains taxes on mutual funds. First, you can make your mutual fund investments in tax-advantaged accounts, such as a 401(k) account, IRA, or HSA. Finally, you can reduce your capital gains taxes on mutual funds through tax-loss harvesting.

As with any investment, it’s important to understand the expenses associated with mutual funds, including the tax impact. That information can help you decide whether mutual funds make sense for your portfolio and allow you to take steps to minimize the income taxes you pay.

CRC# 381199 11/2024

For additional tax-related information, visit our Tax Center—or speak with an E*TRADE Financial Consultant at 877-800-1208.