An individual retirement account can shield your investment income from taxes while you hold the money in the account. If you own a mutual fund in an IRA, you can usually avoid federal taxes until you take the money out. However, if you hold a mutual fund in a regular investment account, you have no such protection. There are ways you can at least temporarily avoid federal taxes, but it becomes difficult over time.
If you sell your fund at a profit, you'll owe capital gains taxes. As of 2013, the long-term capital gains rate, assessed on investments held longer than one year, topped out at 20 percent. Taxes are even higher if you sell your fund after one year or less. If you hold your fund for life to pass it on to your heirs, you won't have to pay capital gains taxes on your profits. However, you won't be able to use the money tied up in the fund, either.
Dividends and Interest
Mutual funds are required by law to pass-through the income they receive from investments to their shareholders. If you own a fund that earns dividends or interest, you'll receive a taxable distribution from the fund at some point during the year. To minimize the amount of taxes you'll have to pay, you can invest in funds that only buy growth investments, such as aggressive stock portfolios. However, there's no guarantee a fund can completely avoid dividends in interest. Even all-stock portfolios often own at least some stocks that pay dividends, and many funds have cash holdings that earn money market dividends.
As with dividends and interest, mutual funds are required to pay out any capital gains they earn from their investments. You can expect your fund to book a profit at some point. Most funds make capital gains distributions once a year, often in December. A fund will always declare the date after which shareholders will receive the distribution, so if you don't own the fund on that date, you can avoid the payout and the related taxes. However, selling the fund at a profit may trigger capital gains taxes, which may wipe out the benefit of avoiding the capital gains distribution.
One way to avoid some or all taxes on a non-IRA mutual fund is to be in a low tax bracket. As of 2013, if you're in the 10 or 15 percent bracket, your long-term capital gains rate is zero. You could sell your fund at a profit without paying tax on it, and you could receive capital gains distributions while also avoiding taxes. Regardless of your tax bracket, you can also avoid taxes on up to $3,000 in interest and ordinary dividend income if your capital losses exceed your gains by that amount.
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