Analyzing tax considerations
Taxes can have a substantial impact on your net return. All mutual funds are required to distribute capital gains to shareholders each year; those gains are subject to capital gains tax in the year they're distributed. However, some funds are managed to minimize those distributions by trading relatively infrequently or taking capital gains into consideration when selecting individual securities to sell. The higher your tax bracket, the more attention you should pay to determining the tax efficiency of a fund held in a taxable account.
Taxes also can be a factor in the timing of your purchase or sale of a mutual fund. If you plan to hold the shares in a taxable account, find out when the fund is scheduled to distribute any dividends or capital gains to shareholders. Consider delaying a purchase until after that date, which often is near year-end. If you buy just before the distribution, you'll owe taxes this year on that money, even if your own shares haven't appreciated. And if you plan to sell a fund anyway, you may minimize taxes by selling before the distribution date.
Also, some funds specialize in holding municipal bonds, which are generally free from federal income tax (though they may be subject to the alternative minimum tax). A municipal bond fund reduces the impact of potential default by any single bond issuer. However, unlike an individual bond, there is no maturity date at which your principal will be returned to you. When evaluating a mutual fund, consider whether you intend to hold it in a taxable or tax-advantaged account.
Note: For municipal bonds held by a fund and issued by a municipality outside the state in which you reside, the interest could be subject to state and local income taxes. Also, municipal bond funds are subject to the same inflation, interest-rate, and credit risks associated with their underlying bonds. As interest rates rise, bond prices typically fall, which can adversely affect a bond fund's performance.
Mutual fund rating services
In addition to doing your own research into mutual funds, you may find mutual fund rating services helpful. These services provide ratings and reports on virtually all of the major mutual funds. Much information is available online, either for free or by subscription. Your public library also may have a subscription.
Many investors prefer to leave the task of plowing through all the data described above to a financial professional, who has experience comparing multiple funds and analyzing how each one might fit your overall portfolio and fill specific investing needs.
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