Mutual Funds for Retirement: How Much Tax You Pay

Mutual funds are common investment vehicles that can be good for smaller investors but can complicate high net worth investors’ tax situations. Because you can’t control the fund and your assets are mixed with others, you sacrifice tax efficiency by investing in mutual funds for retirement.

Like stocks, profits on mutual funds in taxable accounts are subject to a capital gains tax. A capital gain or loss is the difference between what you paid for an investment and what you received when you sold that investment. If you sold an investment for more than what you paid for it, you have a gain.

Unlike stocks, you’ll be held accountable for any capital gains the fund racks up as it trades throughout the year. You have no control over when or what the fund sells or when it distributes these capital gains to you.

Mutual fund portfolio turnover can be accelerated by the need to meet investor requirements for cash, not only costing your commissions, but also potentially increasing the capital gains you incur. Additionally, because capital gains in a mutual fund are distributed to individual shareholders of the fund, you could end up paying taxes on these gains in a year where you don’t sell any shares yourself or even when the overall fund incurs a loss. In other words, you can lose money and still have to pay taxes!

This differs from a personalized, separately managed portfolio that isn’t commingled like a retirement mutual fund. With this option, you can customize the buying and selling of securities according to your tax preferences. As your assets have grown over the years leading up to retirement, your tax situation has likely increased in complexity.

Takeaway: You may be sacrificing tax efficiency if you use mutual funds in a taxable account.

A trust is a fiduciary relationship between three parties. One is the trustor, who gives the trustee the right to control assets for the third party, the beneficiary. Trusts are common with high net worth investors because they have tax advantages and allow for a degree of control in case you’re no longer able to make decisions yourself.

There are a variety of trusts worth discussing with an estate lawyer. However, one deserves specific mention because so many high net worth retirees employ it—generation-skipping trusts. A GST is a legal arrangement where assets are passed directly to your grandchildren, skipping over your children. Your children pass on the opportunity to receive your assets in order to avoid the associated estate taxes. A well-written GST can still benefit your children because any income generated by the assets can be made available directly to them while the assets remain in the trust in the name of your grandchildren.

Aside from financial reasons, a trust may be helpful if your beneficiaries are too young to manage their own finances or unqualified to do so for some other reason. You can also use a trust for charitable reasons, such as establishing a scholarship fund or open space preserve.

A side note on estate taxes: These can be partly mitigated by giving some of your assets away to your heirs as gifts while you are still alive. The current yearly limit is $14,000 per beneficiary each year, without counting against your lifetime gift tax exclusion. Any yearly amount above this counts against your lifetime gift tax exclusion of $5.45 million ($10.9 million for a married couple). The more of your lifetime exclusion you use up, the more of your estate is potentially exposed to estate taxes.

Takeaway: Trusts can be useful for tax planning.