Can I Avoid Federal Taxes if I Have a Mutual Fund Outside of an IRA?

by Craig Woodman

While the old saying about death and taxes being the only two certainties that you will face in life is true, you can use some types of investment strategies to lessen the bite of federal taxes or avoid them altogether. By utilizing different investment vehicles to make your money grow and implementing a tax-reducing strategy, you will have more money to re-invest or use in any other way you desire.

Tax-Free Capital Gains

If you are in either the 10- or 15-percent tax bracket, you can take long-term capital gains at a zero percent tax rate for a limited time. This is an extension of the tax cuts commonly called the Bush-era tax cuts, and it is due to expire in December 2012. Long-term capital gains are from assets that you have held for more than one year. This is a valuable benefit, particularly if you have lost your job, reducing your income, and you have had to sell assets at a gain to pay for living expenses. A married person filing jointly must have less than $69,000 in adjusted gross income to be in the 15-percent bracket.

Mutual Fund Dividends and Capital Gains

In December, while preparing for the end of the year, mutual funds may pay the dividends and capital gains that have been accumulating in the account for the year to their shareholders. The mutual fund company reports the dividends per share to your account but then reduces the share price by the amount of the dividend per share. The account does not increase in value, but you, as a shareholder, now have a taxable event. If you purchase shares in a taxable mutual fund just before this date, this disbursement will be a taxable event. Check with the mutual fund company to see when it pays out its dividends for the year and hold off on large investments until after that date. You will avoid the taxable dividends and capital gains for the year.

Municipal Bond Funds

Mutual funds that invest in municipal bonds are often tax-free. Cities and states often issue bonds that pay tax-free interest. This is an incentive for you to loan money to the municipal government by purchasing a bond, even if the interest rate is lower. Some municipal bonds can cause problems with the Alternative Minimum Tax, so it is wise to search for a tax-free municipal bond fund that limits your exposure to this tax. Most of these funds publish this fact in the prospectus.

Other Options

In addition to IRA accounts as a way to defer federal and state income taxes on your investments, other retirement accounts work the same way. 401k accounts are one way to defer federal taxes on investments. Many other types of retirement accounts exist to offer deferment, particularly to the self-employed. Simplified Employe Pension accounts and a Savings Incentive Match Plan for Employees are two other types of these accounts.