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Taxes and Investments: Mutual Funds

A mutual fund is basically an investment fund, managed by professionals, that pays yearly dividends to its investors when it realizes capital gains. More specifically, a mutual fund is a pool of investors sharing the net gains and losses from securities investments (such as stocks or bonds). Mutual funds allow individuals to participate in potentially high-return investments, backed by the expertise of a mutual fund manager, for a proportionally low up-front cost. If your mutual fund has more net gains than losses at the end of the financial year, it pays out that difference to its shareholders (usually in December or late November). You may choose to receive a check, or reinvest your distribution to buy more shares of the fund. Many different retirement portfolios (including IRA plans, 401k plans, and Keogh plans) will allow you to make investments in mutual funds. Doing so can provide you with substantial benefits, not only upon retirement, but for your annual income taxes as well. If you make an investment in a mutual fund on your own, you will be required to pay taxes on the fund’s distributions ? even if you just purchased the fund and did not receive a distribution yet. A good tax-saving strategy is to put the investment earnings (from your mutual fund) into your retirement plan, which allows you to defer paying taxes on your distribution. If you deposit your investment income into a Roth IRA, you may also be able to avoid paying taxes on your IRA withdrawals if you meet certain requirements (such as age 59 ½ or older, retired, disabled, or a first-time home buyer). Note that you may always withdraw your initial investment from a Roth IRA, minus earnings, without being taxed. When considering whether to make an investment in a mutual fund, it’s a good idea to ask the fund manager whether the mutual fund has booked capital losses (in a previous year) that could replace capital gains in succeeding years. If so, this “carry forward” technique could benefit you because capital losses can be claimed for a tax deduction. You can also look for a mutual fund with a relatively low turnover rate (10% to 20%) which will offer a smaller return on your investment, but it will also limit your tax liability. If you want to take a chance by investing in a mutual fund with a higher turnover rate, it’s recommended that you place the investment earnings into a tax-deferred retirement account. For some, tax-managed mutual funds are a better investment. These funds use different tax strategies to limit what their investors must pay in taxes ? these strategies include keeping the turnover rate low, and selling stocks that have lost value to offset more profitable stocks. The mutual fund may also invest in multiple lots, which allows the fund manager to choose shares with the least capital gains to distribute to the shareholders, minimizing their tax burden. Finally, there are also mutual funds that invest exclusively in bonds. A municipal-bond fund, which buys bonds issued by local governments, is exempt from federal and state taxes.

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