New IRS reporting requirements kick in for fund firms in 2012

BusinessFinanceInternal Revenue ServicePersonal FinanceMutual FundsT. Rowe Price

If you own mutual funds outside a retirement account, you likely have heard from the investment companies asking you to choose your math.

The companies want you to select the method they should use to calculate your "cost basis" — how much you paid for the shares. What you decide can make a difference in your tax bill when you sell.

The fund companies are acting on legislation passed in 2008 that requires brokerages and investment companies to report cost-basis information to the Internal Revenue Service when securities are sold.

The IRS has long known what we sell our securities for. It just never knew what we paid for them. The difference between those two numbers determines how much we will owe in capital gains tax if we sell at a profit, or the size of the tax break we could get if we suffer a loss.

"There is a belief among the politicians and the IRS that people are under-reporting their income, either intentionally or unintentionally, when they sell stock," says Tony Lam, associate tax counsel for T. Rowe Price in Baltimore. "If they don't know their cost basis, they might just put in a number that is not accurate and could be inflated."

Indeed, CCH, the Illinois-based tax information provider, said in 2008 that this new reporting requirement was expected to bring in $7.6 billion to the Treasury over a decade.

Of course, many small investors might welcome having financial institutions work out the math for them. Figuring cost basis can be a headache for those who regularly invest modest sums over a long time.

The new reporting standards are being introduced in waves. And they apply only to taxable accounts, not tax-deferred retirement plans at work.

Brokerages this year, for instance, had to start reporting the cost basis for individual stocks acquired on or after Jan. 1, 2011.

Next year, the reporting mandate kicks in for mutual funds and most exchange-traded funds purchased in 2012 or later. (Cost basis on older shares won't be reported to the IRS.)

In 2013, the cost basis of individual bonds purchased from that year forward must be reported.

Mutual fund companies have been reaching out to clients to ask them to choose among a variety of methods of calculating cost basis.

"It's a big transition period," says Maria Bruno, senior investment analyst with Vanguard.

Investors have been able to sell shares and then later, with their accountant, decide which cost-basis calculation provides the best tax outcome for them, Bruno says. Starting with shares purchased next year, they will have to decide at the time of sale — if not before — which method to use.

Fund companies are offering a variety of methods.

Among them is average cost, in which the cost basis is determined by the average price of all shares within a certain lot.

This is the simplest method, and requires little record-keeping. Many fund companies now as a courtesy calculate clients' cost basis using this method.

The drawback, says Price's Lam, is that investors lose some of their tax-planning capability. Investors, especially those with higher incomes, often try to minimize taxes by offsetting gains and losses.

Investors can do more tax planning if they opt for the "specific identification" method, in which you pick and choose the lot of shares you sell. You might opt to sell your oldest shares first or your most expensive, for instance.

"That will give you the most flexibility, the most potential for tax efficiency," Bruno says.

The drawback: "It requires much more monitoring and much more record-keeping," she says.

All of this can be confusing. Fidelity Investments says it will be adding a new tool to its website next year to help clients figure out the right method for them. Price says so far it hasn't heard much about cost-basis calculations from clients.

If investors don't elect an option, some fund companies say they will use "average cost" to figure the cost basis for clients.

Anna Fink, director of accounting and management consulting with Ellis & Associates in Baltimore, says that option is likely the best one for the typical investor.

eileen.ambrose@baltsun.com

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