Federal income taxes take a bite out of your paycheck and can batter your investments. The Internal Revenue Service considers all income that is not specifically exempted by law to be taxable, regardless of how it's earned. This includes money generated by most mutual funds. You may be able to avoid paying taxes on mutual fund earnings by holding them in a Roth individual retirement account.
You can usually contribute to a Roth IRA if you have earned income, but the amount may be limited by how much you earn, based on your filing status. For the 2013 tax year, you can contribute up to $5,500 -- $6,500 if you are at least 50 years old -- if your modified adjusted gross income is less than $178,000 and you are married and file a joint return. Your allowable contribution is reduced if your MAGI is above this level, and it is eliminated once your MAGI hits $188,000. Different levels apply if you file as single, head of household or married filing separately.
There are few restrictions on who can own shares of a mutual fund. As long as you are not a minor and have the money to make the minimum initial investment, you can usually buy shares. Mutual funds can produce income in three primary ways. They might pay dividends, based on income-producing securities held in the fund's portfolio. They might produce capital gains from trading securities in the portfolio. The net asset value of the fund might increase based on increases in the value of the securities held by the fund. If you sell your mutual fund shares for more than you paid for them, you'll have an additional capital gain. In most cases, all three types of income are fully taxable.
Mutual Funds in a Roth
All of the investments in a Roth IRA, including mutual fund shares, are allowed to grow tax-deferred as long as they remain in the account. Because you don't pay current income taxes on the growth, your retirement money would grow faster inside a Roth than in a taxable investment account. If you leave your investments in your Roth IRA long enough for them to become qualified, you can withdraw the earnings tax-free.
Current and future tax implications of your investments are a powerful consideration when deciding whether to buy your mutual fund shares in a Roth IRA or taxable account. If you'd rather pay taxes on your income now and allow your mutual funds to grow tax-free, holding your shares in a Roth IRA may be a better choice. You'll pay taxes on the income and any growth produced by mutual fund investments in your taxable account, but you'll have greater control over your money.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.