Taxes can be complicated, and for investors in mutual funds, they can be extremely complicated. There can be taxes on dividends and earnings when you own mutual fund shares, in addition to capital gains taxes when you sell your shares in the fund. You don’t even have a say in when to realize a gain in the fund’s holdings because that decision is made by the fund’s manager on behalf of all shareholders.

But once you break things down into the different types of taxes, it’s actually fairly straightforward. Here are the key mutual fund taxes to be aware of and some strategies for how to minimize those taxes.

Mutual fund taxes

Mutual funds can be a great choice for investors because they allow you to hold a diversified portfolio of securities for a relatively small investment. But investing in mutual funds means you don’t have control over the individual holdings in the fund, which is chosen by the fund manager. The fund’s price, or net asset value (NAV), will rise and fall based on the performance of the underlying holdings in the fund.

Even when you still own the fund, taxes on mutual fund shares can be triggered in two ways:

  • Dividends and interest: If the fund holds securities that pay dividends or interest, the fund will distribute your share of those payments to you, and you’ll owe taxes on that income. Some mutual funds, such as municipal bond funds, focus on investments that are exempt from federal income tax. If you do receive dividends or interest from a fund you hold, you’ll likely receive an IRS tax form that shows your income from the fund for the year. The form may come from the fund company itself, or from your online broker.
  • Capital gains: The fund manager may sell securities in the fund for a profit, triggering a capital gains tax. The tax impact will depend on how long the fund held the shares that were sold. The capital gains are distributed, typically once a year, to the fund’s shareholders, who will owe taxes on the gains.

For more details on the taxation of investment income, check out IRS Publication 550.

Taxes on mutual funds when you sell shares

If the securities held in your mutual fund perform well, the fund’s NAV will appreciate, giving you a gain on your original purchase. You’ll need to pay taxes on this gain, but figuring out exactly how much you owe can be complicated.

If you bought your shares all at once, the calculation will be relatively simple. You subtract the price you paid per share from the price you sold at and the difference equals your per-share gain. But most people buy mutual funds consistently over time, meaning you will have paid several different prices for your shares. You can either use the average cost of all the shares you own to calculate your gain, or you can use specific shares with a specific cost basis.

It also matters how long you’ve held your shares. If you’ve owned the shares for more than a year, you may get a break on the capital gains tax rate because the gain is considered long term. For gains on shares held less than one year, you’ll pay taxes at the ordinary income rate.

How to minimize taxes on mutual funds

Taxes on mutual funds are a sign that you’ve either received some form of investment income or you’ve realized a gain, so they’re not all bad. But avoiding taxes can help you achieve higher long-term returns. Here are some of the best ways to minimize taxes on mutual fund investments:

  • Hold shares in tax-advantaged accounts: One of the easiest ways to avoid taxes on mutual fund investments is to hold the shares in tax-advantaged accounts such as a 401(k) or a traditional or Roth IRA. Your investments will be allowed to grow tax-free, meaning you won’t pay taxes on the distributions you receive or gains you realize. You won’t pay taxes on withdrawals either, in the case of a Roth IRA.
  • Hold funds for the long term: By holding funds for more than one year, you’ll be able to pay taxes at the long-term capital gains rate, which is a major advantage for most investors.
  • Avoid certain types of funds: If you want to avoid taxes, you’ll probably want to steer clear of funds focused on dividends or funds with high portfolio turnover, both of which can cause a lot of realized gains. Index funds may be your best bet, because they typically pay modest dividends and have low turnover.
  • Tax-loss harvesting: Using a tax-loss harvesting strategy involves selling some investments at a loss to offset your gains, allowing you to pay less in taxes.

You can also limit your tax exposure by holding exchange-traded funds (ETFs) instead of mutual funds. ETFs often hold similar investments to their mutual fund counterparts, but aren’t required to distribute realized capital gains, making them more tax efficient.

Bottom line

Taxes on mutual funds can be complicated because you can be taxed on dividends and the fund’s gains even before you’ve sold your shares. Of course, you’ll also be taxed on any gain in the fund’s value when you decide to sell. The simplest way to avoid this is to own mutual funds in tax-advantaged retirement accounts such as IRAs and 401(k)s. You can also make sure to hold the investments for the long term, so that if you do owe taxes, you’ll pay them at the lower long-term capital gains rate.