Fund, in contrast, had a 200% turnover rate, completely turning over all its holdings twice last year. Investors in this Putnam fund received over $1 per share in taxable gains in 1996.
Look for tax-efficient funds. Some funds attempt to minimize taxable distributions to investors. They sell losers to offset winners, following accounting practices designed to reduce taxable income. Index funds are often good examples. “I like Schwab 1000,” says Powells, referring to a fund designed to track the 1,000 largest publicly-traded U.S. companies. Since its inception in 1991, turnover has been 1%-3% per year, and the fund has yet to make a capital gains distribution.
Buy for the long term. “The more you trade, the more likely you’ll incur taxable gains,” says Gale P. McEvilley, a financial Planner in Charlotte, North Carolina. “If you buy and hold, you’ll owe tax on interest and dividends but not as much tax on capital gains.”
Along those same lines, don’t be too quick to switch from one fund to another, even within the same fund “family.” Let’s say, for example, you’ve held Fidelity Magellan for several years and then switch to Fidelity Contrafund. “Fund switching is simple to do and you may never actually receive any money,” says Willock. “Most people are not even aware that they’re creating a taxable event, but each fund switch must be reported to the IRS and you’ll owe tax on any gains.”
If you must talc gains, couple them with losses. “You should track your investment activities throughout the year to determine whether you have net gains or net losses,” says Joe Haywood, a financial planner with AFP Group in Los Angeles. “If you have net gains, you can sell other securities on which you’ve lost money. These losses can also offset capital gains distributions from mutual funds.” Ideally, you’ll wind up the year with a $3,000 net capital loss because that amount can be fully deducted from your other income. (If your losses are larger, the excess must be “carried forward” to future years.)
Larry D. Bailey, partner in the national tax services office of Coopers & Lybrand in Washington, D.C., says you should meet with your tax or financial adviser around mid-November each year to get a fairly solid estimate of your capital gains exposure. Suppose this November you calculate that you’ll have $5,000 in net capital gains for the year. If you take no action, you might owe $1,270 to the IRS (see sidebar). However, suppose you sell stocks, bonds or mutual funds for an $8,000 loss. Now you have a $3,000 net loss that’s fully deductible. This will save you $840-$1,188 in taxes depending on your bracket, instead of a $1,270 tax obligation.
What do you do after you take your losses? You can wait 31 days and buy back the stocks, bonds or funds that you’ve sold. If you’d rather not wait, you can buy similar but not identical securities right away.
Keep good records. When you sell securities, don’t forget to add all reinvested amounts to