We normally think of mutual funds as investment vehicles—which they are—but they can also offer valuable ways to save money on income taxes this spring and beyond.
There are steps you can take with mutual funds right now that can lower your tax liability either for the 2011 tax year or, failing that, for 2012. Yes, there are ways to save on taxes with mutual funds!
Some of these are time sensitive, so you’ll want to either make your moves now, or position yourself to be able to take advantage when tax time comes around next year. The important thing is to move on this — the windows close quickly.
Municipal Bond Funds
Mutual funds that invest in municipal bonds will carry the same tax exempt income advantages as the bonds themselves. But they will do so in a way that enables you to hold a portfolio of tax exempt bonds, and that will lower the risk considerably as compared to holding just one or two bonds independently.
Another advantage of municipal bond funds is that they can have double-tax exempt status — tax exempt not only for federal taxes, but also for state income taxes as well. This is accomplished through a municipal bond fund that invests in bonds issued only by state and municipal entities located in your state of residence.
A municipal bond mutual fund will give you this tax exempt income, with the added security of diversification and professional management.
Year end tax sales
Just as with stocks, you can sell off mutual funds that have fallen in value since they were purchased. Since the IRS allows you to deduct up to $3,000 in capital losses in any one year, you can sell enough mutual funds to maximize this loss. Any losses in excess of $3,000 can be carried forward into future years. You’ve already suffered a loss on the investment, so you may as well try to recover at least part of it through a tax sale.
There’s one important caveat when it comes to tax harvesting investment sales: under IRS regulations, you can’t take a capital loss if you buy back the security within 31 days of the sale. So make sure that any mutual funds sold are ones you’ve given up on.
Mutual funds offer an advantage in this regard, since you can sell part of a postion, without running into an “odd lot” sale (less than 100 shares) that ocurrs with stock sales, raising the cost of the sale.
Mutual funds in tax sheltered plans
Like any other security, mutual funds can be used as the vehicle to for investing the money held in tax sheltered retirement plans. Many people shy away from tax sheltered investments due either to low returns (on safe, fixed rate securities) or confusion or inexperience with stocks and other risk type investments.
But mutual funds offer the advantage of a professionally managed investment fund at relatively low cost.
You don’t need to get involved in individual investment choices, and best of all, mutual funds make it easy to dollar cost average your investments, lowering the risk even more.
Any income earned on the mutual funds held in a tax sheltered plan — interest, dividends or capital gains — will accumulate on a tax deferred basis until retirement when you’ll withdraw the money in small increments at a time in your life when your tax liability will probably be lower than it is today.
It isn’t that other investment vehicles can’t do the same thing, but mutual funds can do it systematically, economically, and with little hands on management.
Open an IRA in 2012 for 2011
Though contributions made to a Roth IRA are not tax deductible, those made to a traditional IRA are for many taxpayers whose income meets IRS guidelines. And one more piece of good news: it’s still not too late to make tax deductible contributions for 2011!
You can make a tax deductible IRA contribution for 2011 right up through April 15th of the year.
That means that even if you didn’t have the money to fund an IRA contribution during 2011, you can still make a contribution in 2012 that will improve your tax liability. Mutual funds are an easy and convenient way to do this. No need to get involved in choosing the right stocks, a mutual fund will take care of that for you, and help with diversification too—all at a low price.
Creating a new long-term asset AND getting a tax deduction for doing it—that’s one of the best deals around!
bovespa says
Interesting, here in Brazil we can use a investment called PGBL to pay lower taxs
krantcents says
Deferring taxes or avoidance has become an obsession! In about 5+ years, I will find out if it was worth it! I hope to be in a lower tax bracket , but I hedge with a Roth IRA too.
Glen Craig says
So you’ll be retired in about 5 years? Nice!
Little House says
Part of my savings goal this year is to open a tax deferred account, probably an IRA. Hopefully that will save me money in the long run!
Glen Craig says
Do it! For some accounts you don’t need much to open one up. Don’t wait until the last minute.