If costs are important because they take away a part of the money you make when investing in mutual funds, then perhaps the biggest cost of them all is taxes. And as such, once you understand how taxes are levied on mutual funds, you can actually find ways to dramatically reduce the tax burden on the growth of your mutual fund investments.
So, if you want to pay the least amount of taxes possible on your mutual funds when you invest using a taxable account, it’ll help if you first know how mutual funds are taxed. And to make things simple, we’ll keep this discussion focused on federal taxes.
Now, there are two types of mutual fund income that are taxed: dividends and capital gains. And each of these is taxed differently, depending on the type of dividend and the type of capital gain. So, let’s dig a bit deeper into these different types.
Stock Dividends
Stock dividends are payments that a company distributes out of its profits on a regular basis, and they can be a major source of the money you make when investing in mutual funds. Now, here’s a very brief history lesson for you: Before the Jobs and Growth Tax Relief Reconciliation Act of 2003, stock dividends were actually taxed at your marginal (highest) income tax rate.
However, the Jobs and Growth Tax Relief Reconciliation Act of 2003 provided relief to most investors who receive stock dividends, lowering the income tax rates on dividends that are “qualified.” And as a result, now, for the 2024 tax year, “qualified” dividend income tax rates have been reduced to a maximum of 20 percent.
Better yet, if you’re in the 10 percent federal income tax bracket, your qualified dividend income tax rates have been reduced to zero percent in 2024. And, many people in the 12 percent federal income tax bracket also have their qualified dividend income tax rates reduced to zero percent in 2024 as well.
“So, how can I take advantage of this?” you ask. Well, if you want to be a tax-savvy investor when you use a taxable account, check with your mutual fund company to see if the stock mutual fund that you want to own invests mostly in stocks that pay “qualified” dividends.
For instance, Vanguard’s Total Stock Market Index Fund had over 90 percent of its dividends qualified in 2024. On the flip side, Vanguard’s Total International Stock Index Fund had 61 percent of its dividends qualified in 2024. And in addition to this, Vanguard’s Total International Stock Index Fund also qualifies for the foreign tax credit, which helps to directly reduce your tax bill. For these reasons, both of these funds are well-suited for taxable accounts.
Bond Dividends
Bond mutual fund dividends are actually interest payments, but they’re described as dividends when distributed to investors. But unlike some stock dividends, bond dividends are not qualified for the lower tax rate.
Because of this, dividends from taxable bond funds in taxable accounts are taxed at your marginal income tax rate—up to 37 percent in 2024. So, if you want to be tax-savvy, invest in taxable bonds by using a tax-sheltered account such as a 401(k) or IRA whenever you can.
Capital Gains
Okay. Now that we have a basic understanding of stock and bond dividends, let’s talk about capital gains. A capital gain occurs when a stock, bond, or mutual fund is sold for a profit.
This profit is the difference between the purchase cost of stock, bond, or mutual fund shares and their price when sold. On the other hand, if the stock, bond, or mutual fund share is sold below its purchase cost, the difference is a capital loss.
Now, there are two types of capital gains: short-term and long-term.
A short-term capital gain is a profit on the sale of a stock, bond, or mutual fund share that’s held for 12 months or less. And a long-term capital gain is a profit on the sale of a stock, bond, or mutual fund share that’s held for more than one year.
“Well, why does all of this matter?” you ask?
Because tax rates for short-term and long-term capital gains are not the same. So, it’s very important for tax-savvy investors to understand the difference.
You see, short-term capital gains are taxed as ordinary income at your highest marginal income tax rate (up to 37 percent in 2024). On the other hand, long-term capital gains are taxed similarly to qualified dividends, enjoying a maximum tax rate of 20 percent—almost half.
So, one of the easiest ways to cut mutual fund taxes significantly is to hold mutual funds for more than 12 months—ideally for decades, until you need the money. In other words, buying and holding wisely is an effective strategy in your taxable accounts.
