If you just wrote the IRS a big check from investment gains, please keep reading. I’ll tell you how to minimize that tax next year — and not sacrifice potential gains.
In the old days, you could minimize tax on investments simply by not selling. In today’s world, most of your investments are probably in mutual funds. They have many advantages. But some funds buy and sell their investments so much that – even if you have sold nothing – the funds have generated a lot of taxable gains, which are passed onto you. It’s particularly expensive if the fund sold shares held for a year or less. That so-called “short-term gain” is taxed at your highest possible rate.
To minimize tax, buy “passive” funds, like index funds. Passive funds buy and sell shares infrequently. So, they generate low levels of taxable gains. An example: Vanguard’s total US stock market fund sold 3% of its holdings in the past year. The average mutual fund in the US sells 85% of its holdings in a given year. Many hedge funds have “turnover” over 100%. That means you have a much higher tax bill. Even worse, you didn’t sell, so you’ll have to raid your bank account to pay the IRS if you’re reinvesting dividends. And remember: Starting in 2013, if you and your spouse have “adjusted gross income” over $250,000 (single filers – $200,000), your tax will be even higher, with the new 3.8% Medicare surcharge.
If you use “passive” funds, your gains accumulate with a modest annual tax bill, mostly from dividends. If you hold the shares for years, you’ll likely have a tax bill when you sell. But later is always better than sooner, and you’ll pay tax at long-term rates, which can be half the rate on short-term gains.
The IRS wants you to be a long-term investor – not a frequent trader. I follow their advice. You should too.