How to Avoid Capital Gains Tax on Mutual Funds?

Owning mutual funds in a taxable account can lead to tax liabilities. These funds generate taxes for investors in two ways: when the fund itself sells securities for a profit and passes those gains to shareholders as distributions, and when an investor sells their own shares for more than their purchase price. A grasp of how these gains are generated and taxed is the first step toward managing them effectively and minimizing the tax burden on your investment returns.

Understanding Mutual Fund Capital Gains and Taxation

A mutual fund investment can trigger a tax bill even if you do not sell your shares. This happens through a capital gains distribution, where a fund distributes net gains from selling securities in its portfolio to shareholders, typically once a year. These distributions, reported on IRS Form 1099-DIV, are taxable regardless of whether you take them in cash or reinvest them.

The second taxable event occurs when you personally sell your shares in the mutual fund for a profit. This gain is calculated by subtracting your cost basis—what you originally paid for the shares, including any reinvested dividends—from the sale proceeds. Financial institutions report this information to you and the IRS on Form 1099-B.

The tax rate applied to these gains depends on the holding period. Gains on assets held for one year or less are classified as short-term and are taxed at your ordinary income tax rates. Gains on assets held for more than one year are considered long-term and benefit from lower tax rates of 0%, 15%, or 20% for 2025, based on your total taxable income and filing status.

A fund’s capital gain distribution is taxed to you as a long-term capital gain, irrespective of how long you have personally owned the fund shares. This is because the tax treatment is determined by how long the fund held the underlying security that was sold. For example, a single filer with a taxable income up to $48,350 in 2025 would pay a 0% rate on long-term gains.

Utilizing Tax-Advantaged Retirement Accounts

Holding mutual funds within a tax-advantaged retirement account like a Traditional IRA, Roth IRA, 401(k), or Health Savings Account (HSA) is an effective way to avoid annual taxes. Inside these accounts, capital gains distributions and profits from selling funds do not create a current tax liability. This allows your investments to grow in a tax-sheltered environment, compounding without the drag of yearly taxes.

The tax treatment differs based on the account type. With traditional accounts like a 401(k) or Traditional IRA, taxes are deferred, and you will pay ordinary income tax on withdrawals in retirement. For Roth accounts, such as a Roth IRA, qualified withdrawals in retirement are completely tax-free, provided you meet age and holding period requirements.

Strategic Approaches for Taxable Brokerage Accounts

For funds in standard brokerage accounts, several strategies can manage the tax impact:

• Tax-loss harvesting: This involves selling an investment that has decreased in value to realize a capital loss. This loss can then be used on your tax return to offset capital gains from other investments. Should your capital losses exceed your gains, you can use up to $3,000 of the excess loss to offset your ordinary income each year, with any remainder carried forward.
• Donate appreciated shares: Instead of selling a highly appreciated mutual fund, you can donate the shares directly to a qualified charity. If you have held the shares for more than one year, you can generally claim a tax deduction for the full fair market value and avoid paying the capital gains tax that would have been due.
• Gift appreciated shares: Give shares to a family member in a lower tax bracket. For 2025, you can give up to $19,000 to an individual without a gift tax. The recipient assumes your cost basis and holding period and may pay little to no tax upon selling if they are in a lower tax bracket.
• Hold investments long-term: Hold a fund for more than one year before selling. This ensures any profit is classified as a long-term capital gain, which qualifies for lower tax rates than short-term gains.

Selecting Tax-Efficient Investment Vehicles

Choosing inherently tax-efficient investments can proactively manage tax liability:

• Consider the turnover ratio: This metric shows how often a fund manager trades assets. A high turnover ratio can lead to more frequent capital gains distributions, increasing the tax burden for investors.
• Choose index funds: These funds replicate a market index and have low turnover ratios because managers are not actively trading. This results in fewer capital gains being passed on to investors, making them a tax-efficient choice compared to actively managed funds.
• Invest in Exchange-Traded Funds (ETFs): ETFs have a structural advantage that often makes them more tax-efficient than mutual funds. Their unique creation and redemption process allows them to handle investor sales without having to sell underlying securities, which helps avoid realizing capital gains.
• Look into tax-managed funds: These funds are designed with the primary goal of reducing the tax impact on shareholders. Managers use strategies like minimizing turnover and offsetting gains with losses to improve tax efficiency.

Managing Inherited Mutual Funds

Inherited mutual funds benefit from a “stepped-up basis.” When you inherit shares, your cost basis is not the original owner’s purchase price. Instead, the basis is “stepped up” to the fair market value of the shares on the date of the original owner’s death.

This provision can erase years of accumulated capital gains. For example, if a parent bought shares for $20,000 that were worth $100,000 at their death, the $80,000 in appreciation would have been a taxable gain for the parent if they had sold them.

The heir’s cost basis becomes $100,000. This allows the heir to sell the shares for their current market value and owe little to no capital gains tax. The step-up in basis allows wealth to be transferred without the burden of the capital gains tax accrued during the original owner’s life.