How to Avoid Capital Gains Tax on Mutual Funds

When you sell an investment asset for a profit, you’ll eventually owe capital gains taxes. However, active investors should be aware that the IRS offers several strategies to defer these taxes. Effective tax planning can be especially beneficial for complex investments like mutual funds. If you want to minimize capital gains tax on mutual funds when adjusting your portfolio, consider these asset management strategies.

To proactively plan for potential tax liabilities, consider working with a financial advisor who specializes in tax strategies.

Capital Gains Taxes and Mutual Funds

Mutual funds are a popular investment vehicle because of the balance they can potentially bring to your portfolio. However, not everyone thinks about the potential tax consequences of investing in a mutual fund. This is a critical consideration before you invest.

There are two main ways that you pay taxes on a mutual fund.

Ordinary Income Taxes

If you have an income-generating fund, you may pay ordinary income taxes on the money the fund distributes. Yields such as interest and non-qualified dividends are subject to ordinary income tax for the year in which you receive them.

Many mutual funds generate these payments, so it is important to prepare for this tax liability come tax time.

Capital Gains Taxes

Mutual funds typically incur capital gains taxes. Whenever you sell an investment asset or receive qualified dividend payments, you will owe capital gains taxes on any profit.

Say you invest in a mutual fund at $100 per share, and you sell it for $150. You would owe capital gains taxes on the $50 of profit that you collected from that sale.

You may also owe capital gains taxes based on the fund’s activity. A mutual fund is a portfolio of underlying assets. Each share represents a percentage of ownership of those assets as a whole.

When a mutual fund sells assets in its portfolio for a gain, it can, under most circumstances, do one of two things.

The fund will reinvest the proceeds in new assets.
The fund will pass the proceeds from any sale back to its investors on a per-share basis. This is a capital gains distribution.

When a mutual fund is competently managed, you typically do not see any tax consequences from a reinvestment. However, if you receive a capital gains distribution, you may owe capital gains taxes on that money.

This is how mutual funds can create tax liability for their investors even if you don’t sell a single share.

How to Manage Mutual Fund Capital Gains Taxes

A couple review how to avoid capital gains tax on mutual funds.

There are a few strategies to manage capital gains taxes on your mutual funds.

1. Hold Funds in a Retirement Account

The easiest way to manage any form of capital gains tax is to hold your investments in a qualified retirement account.

As a general rule, the IRS does not consider the sale or management of these assets a tax event until you make a withdrawal. This means you can sell shares of your mutual fund or collect a capital gains distribution without paying the typical taxes, so long as you keep the money in that retirement account.

However, remember that you will ultimately owe any applicable taxes upon withdrawal.

2. Capital Gains Distribution

Outside of a qualified, tax-advantaged retirement account, there’s not much you can do to avoid taxes on a capital gains distribution. Generally speaking, the best way to manage taxes on capital gains distributions is to avoid incurring them.

Look for funds that have a low turnover ratio. This means that they tend to sell and move assets less frequently than other funds. The longer a mutual fund holds its assets, the less often it will generate sales and distributions.

Also, look for funds that tend to reinvest profits rather than issuing distributions. Again this will often, but not necessarily always, allow you to avoid tax events. Index funds often manage assets this way, so they’re a good place to start.

If you already own a fund that regularly issues capital gains distributions in a taxable account, consider whether it makes sense to hold it there. Moving high-turnover funds into a tax-advantaged account and keeping low-turnover or index funds in your taxable account is a straightforward way to reduce the tax drag on your overall portfolio.

3. Long-Term Capital Gains

Try not to sell assets that you have held for less than a year. If you sell something within a year of purchase, it is a short-term investment and is subject to ordinary income tax.

If you sell something after holding it for a full year, it is subject to the considerably lower capital gains rate.

4. Manage Shares

When you sell shares of a mutual fund or another investable asset, you calculate your profit based on what you paid for the underlying asset.

Referring to our example above, you buy shares of a mutual fund for $100 and sell them for $150. You will then pay tax on the $50 difference.

Now, let’s say you invest in this mutual fund over time, paying different amounts per share with each investment. In this case, you can choose to specify which shares you have decided to sell. Your taxable profits will be based on that difference.

For example, say you bought three shares in a mutual fund, paying $100, $120, and $140 per share. You now sell one share for $150. No matter which shares you sell, you will collect the $150.

However, if you specify that you sold the most recent share, you will only owe taxes on $10 worth of capital gains. This is the $150 sale price subtracted by the $140 purchase price.

This kind of management does have a catch. Ideally, your fund will continue to grow, which means you will owe even more in taxes when you eventually sell the $100 and $120 shares. However, if there’s value in managing your cash flow this way, it is a valid tax planning tool.

5. Tax-Loss Harvesting

Finally, many investors employ a tool called tax loss harvesting, which can be tricky.

Capital gains taxes are based on net profits over the course of the year.

Add up all of your profits from selling profitable investment assets.
Subtract all of your losses from selling unprofitable investment assets.
You then pay taxes on the final amount.

This means that you can sell some assets for a loss in order to minimize your total capital gains for a given year.

For example, say you have the $50 gain from selling a share of your mutual fund. Say you also have a stock that is currently worth $20 less than you paid for it. You can sell that stock before the end of the year, realizing a $20 loss. This would partially offset the gain from your mutual fund, bringing your total taxable gains down to $30.

Drawbacks of Tax-Loss Harvesting

One important rule to keep in mind is the wash-sale rule. The IRS prohibits you from claiming a loss on a sale if you repurchase the same or a substantially identical security within 30 days before or after the sale.

If you trigger the wash-sale rule, the loss is invalid, and you lose the tax benefit. To stay in compliance, consider replacing the sold fund with a similar, but not identical, fund during the 30-day window.

The problem with tax-loss harvesting, of course, is that it involves taking a loss. This strategy is generally a good idea if you have investments that you were going to sell anyway. It’s not worth liquidating a good investment early just for the tax break.

It can be worthwhile, though, to time your exit from a bad investment if it can help you offset taxes elsewhere.

Why Cost Basis Matters

One of the most overlooked parts of mutual fund investing is cost basis. This plays a major role in determining how much tax you owe when you sell shares.

Cost basis is generally the amount you pay for an investment. This includes any shares you buy through reinvested dividends or capital gains distributions.

This matters most for investors who contribute to a fund over time. Each purchase may occur at a different share price, creating multiple tax lots with different cost bases. When you sell, the taxable gain depends on which shares you sell and their original sales price.

To illustrate, assume the following:

You buy 100 shares of a mutual fund at $20 per share ($2,000 total).
You later buy another 100 shares at $30 per share ($3,000 total).
Your total investment is $5,000 across 200 shares, giving you an average cost of $25 per share ($5,000 divided by 200 shares).

If you sell 100 shares at $40 per share ($4,000 total), your taxable gain depends on which shares the IRS considers sold.

Using the average cost method, your gain would be $1,500 ($4,000 – $2,500).
Using first-in-first-out, your gain would be $2,000 ($4,000 – $2,000).
Using specific identification and selling the higher-cost shares first, your gain would be only $1,000 ($4,000 – $3,000).

Reinvesting Dividends

Reinvested dividends add another layer that many investors miss. Those distributions may be taxable in the year you receive them.

Reinvesting them increases your cost basis because you use those funds to purchase additional shares. Investors who do not account for those reinvested distributions risk overstating their gain and paying more tax than they owe when they eventually sell.

Most brokerage firms track cost basis automatically and report it on tax forms, but their default accounting method may not be the most tax-efficient option for your situation. Understanding which method your broker applies and whether it is the best approach is a step worth taking before you sell.

Bottom Line

There are two main ways you can get taxed on a mutual fund: by selling your shares or by collecting a capital gains distribution. While you can’t defer taxes on those gains entirely, you can manage them using several investment strategies. Therefore, it is critical to understand how taxes on mutual funds work, so you can properly plan for any tax that you may owe, depending on what you want to do with your investments.

Tips for Tax Planning

For many investors, mutual funds are an excellent way to balance diversification with gains. A financial advisor can help you implement a strategy like this. SmartAsset’s free tool matches you with vetted financial advisors who serve your area. You can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
We have gone into even more depth on how all of this may work for you in our deep dive into how taxes work with mutual funds.