Mutual funds are the backbone of investment strategies for many Americans. There are good reasons for this popularity. Mutual funds reduce risks for nonprofessional investors by spreading the risk over a number of companies in each fund and offering a wide variety of choices covering different sectors varying in risk. But sometimes an investor’s best choice is to sell a mutual fund. One of the factors you should consider when selling is time of year – but under only very limited circumstances.
End of the Year
The end of the year is the best time to sell a mutual fund for tax purposes. Funds sell shares in stocks within their portfolio throughout the year. If the sale price is higher than the earlier purchase price, the owner of the fund will have to pay capital gains tax on the profit at the end of the year, generally in November or December. Taxes eat up 15 percent of long-term capital gains, 20 percent for investors in the highest tax bracket. The bill is often even more painful for short-term capital gains, which require taxes at the rate of ordinary earnings.
If these taxes are high enough, “You might consider harvesting losses,” advises John Waggoner of USA Today. In other words, you could offset these taxes by selling a mutual fund that has lost money. For example, if you bought 1,000 shares of mutual fund “A” for $10 a share and sell it when it has fallen to $8 per share, you have a capital gains loss of $2 X 1,000, or $2,000. This loss will cancel $2,000 in short-term and long-term gains from another fund’s dividends and sales of individual stocks. You can deduct up to $3,000 a year. Losses greater than $3,000 can be carried into the next tax year.
Picking Losers to Sell
But not all losing funds should be sold to offset taxes from other investments. The primary criterion for selling a fund is the underlying strength of instrument. One sign it’s time to sell is failure to match the index for the fund’s segment or inability to keep up with most managers in that segment for more than a year. Other signals are a switch to a new manager who does not meet your standards, or implementation of a new investing strategy you don’t like.
Aside from selling losing mutual fund accounts, there are other ways to avoid capital gains taxes. One is to invest in “tax managed” funds, which try to balance capital gains and losses within the fund. You could also buy a tax-deferred retirement account such as a 401(k) plan. But be aware that when you withdraw money from a traditional IRA of 401(k) plan, the entire amount is taxable income.
Gene Linn started writing professionally in 1980 and has deep experience as a reporter. He has written for such publications as UPI, Bloomberg and the Equities.com. He earned a Bachelor of Science in journalism and a Master of Arts in East Asian studies from the University of Kansas.