Maybe you were invested in a red-hot fund last year. You know, one of those funds that returned more than 100%.
Or perhaps you watched in frustration as a fund that slumped for the year. Finally, you sold some shares to put that money elsewhere.
If you sold fund shares last year in an account that isn't tax-deferred--that is, not within an IRA or 401(k)--you triggered either a taxable capital gain or a deductible loss. Which means you have to deal with the Internal Revenue Service. Ugh.
First, some good news: Even if you have a capital gain on a fund sale, your tax bill might not be as big as you think. Why? If you've owned the fund for several years, you've probably been paying taxes all along. A fund is required to distribute to shareholders each year all net realized capital gains. You've been recording those distributions on your tax return each year, and paying taxes accordingly.
Let's say you invested $10,000 in XYZ Fund at $10 a share in 1997. That means you held 1,000 shares of the fund. Now, let's say that in 1998, XYZ made a capital gains distribution of $2 a share. You received a payment of $2,000 ($2 x 1,000 shares), either in cash or, more likely, in new shares of the fund (since most fund owners reinvest their gains).
That distribution was reported as part of your investment income for 1998, and taxed as such. In addition, when the distribution was paid, your fund company reduced the market price of the fund's shares to reflect it. To simplify the example, assume the market price of the fund--the net asset value, or NAV, was $12.50 a share when the distribution was paid. A distribution of $2 a share would have reduced the fund price to $10.50 a share.
The upshot is that when you finally sell a fund, the difference between your original per-share purchase price and the current market price per share may be surprisingly narrow, thanks to those distributions. And any long-term capital gain--a gain on a security held more than one year--is taxed at a maximum of 20%, well below regular income tax rates.
Now comes the bad news: Even though any capital gains tax bill from a fund sale may be smaller than you fear, calculating your net gain or loss can be a nightmare, especially if you want to minimize your tax bite.
The biggest challenge faces investors who sell a portion of their shares in a particular fund, rather than the entire position.
For starters, you have the issue of those reinvested capital gains.
Let's say you bought 1,000 shares of ABC Fund in 1998 at a price of $10 a share. In 1999, the fund distributed gains of $1 a share, giving you $1,000 ($1 x 1,000 shares). Because you arranged with your fund company to automatically reinvest distributions, you received additional shares of ABC.
Shares received through distributions are priced at the new NAV on the day the money is reinvested. Let's say in this case that the new NAV on that day was $12. Let's further assume that in 2000, you plowed an additional $25,000 into ABC at $13 a share.
It's 2001. Assume you sell 1,000 shares at $14 a share. How much did you make on the sale? Was it a profit of $4 a share, based on the original $10 price paid in 1998? Was it a profit of $2 a share, based on the shares received via reinvestment at $12 in 1999? Or was it a profit of just $1 a share, based on the new shares you bought at $13 in 2001?
You can see the potential for a huge math headache. And just imagine if you've owned the fund for decades, constantly investing and reinvesting.
But you do have choices when it comes to fund accounting. Boni Callaway, education coordinator for Invesco Funds, notes that the IRS allows four ways to calculate gains or losses on sales of fund shares. Which method you choose can make a big difference in how much you'll owe.
Even before explaining the methods, a very important note: Once you choose one of these methods for a particular fund, you're stuck with that method until you completely sell out of that investment. So, if you selected a method for your fund a couple of years ago, and sold additional shares since, you'll have to use whichever method you used in the past.
You must save past tax returns and fund statements, because neither the IRS nor the fund company will remind you which method you used in the past.
However, you can use different methods for different funds.
Here's a look at each accounting method:
* First in, first out. The name speaks for itself. Under FIFO, if you're making a partial sale of your fund shares, the first shares you purchased are the first shares you sell.
Chances are, if you're a long-term investor, you saw your stock funds rise in value significantly throughout the '90s bull market. By using this method, you'd be selling the oldest--and presumably, lowest-cost--shares first, thereby recording the biggest capital gains. And paying the most taxes.
It should come as no surprise, then, that if you fail to tell the IRS that you are using some other method, the IRS will assume FIFO.
Who should avoid FIFO? Many people--particularly all those investors whose fund shares have risen significantly in recent years, says Rande Spiegelman, manager of KPMG's personal financial planning services in San Francisco. That means if you own a tech fund, a telecommunications fund or a growth-oriented fund, FIFO may not be for you.
"But if you own a value fund and it lost money, and you sold some shares last year, then FIFO may be the best option," he said.
* Specific identification. Of the four options, specific identification gives you the most control in determining gains or losses for tax purposes. That's because this method let's you decide which specific shares you intend to sell when you sell them.
"Specific identification is still probably your best option," Spiegelman notes.
For instance, imagine that you bought 1,000 shares of a fund at $10 a share two years ago, 100 more shares at $11 a share 18 months ago through reinvested distributions, and 500 more at $20 last month. But immediately thereafter, the fund's NAV dips to $16 a share, at which point you sell some shares.
If you want to record a tax-deductible short-term loss, you can tell your fund company that you want to sell those $20 shares to lock in a loss of $4 per share.
Or, if you want to minimize taxes, you could tell the fund to sell the $11 shares you got by reinvesting, rather than those that you originally purchased for $10, thereby lowering your net gain.
The problem is, if you sold shares last year without specifically telling your fund which shares to sell, you can't use this method for taxes this year.
In order to use this method, you must notify your fund company, preferably in writing, at the same time you place your order to sell. Some online brokers may not allow you to specify shares on Internet trades, so you may want to call to place such orders.
What's more, you should seek written notification from your fund company of the receipt of your letter and keep that receipt in your records.
* Average cost. If you're doing your own taxes, there's a good chance you'll use this method, which is sometimes called "average cost, single category."
The big reason is convenience. Most fund companies and brokerages, including Charles Schwab, Salomon Smith Barney, Vanguard Group, T. Rowe Price and Invesco, routinely provide a year-end calculation of gains or losses using the average cost method. Some brokerage statements list detailed purchase information to make it easier for you to use any of these methods.
The average-cost method determines how much you paid for all of your fund shares over time, and divides the total by the number of shares you own. So, if you own 100 shares at a total cost of $1,000, the average-cost method would give you a tax basis of $10 per share--even if you paid $15 for some, $5 for others.
Your capital gain or loss on any fund shares sold would be the difference between the price of the shares when sold and the per-share average cost. You still may have short-term or long-term gains or losses: To determine your holding period, the shares disposed of are considered to be those acquired first, a FIFO-like method.
This method will almost never yield the absolute best tax results. Indeed, Spiegelman warns that although "average cost is convenient, it's probably not your best option. Specific identification is."
But if you can't use specific identification and your choice is between FIFO or average cost, then average cost may work to your advantage when selling shares of a fund that has delivered significant gains since you first invested.
Warning: Because the IRS defaults to FIFO, remember to note on Schedule D that you are using average cost. In the box that asks when you acquired the shares, if you write "various" the IRS will know you're averaging.
* Average cost, double category. Like average cost, single category, this method takes your total cost and divides by the number of shares owned.
However, average cost, double category first divides your holdings into two separate buckets--one containing your long-term investments (fund shares held for more than a year), the other containing fund shares held less than a year.
Long-term capital gains are taxed at a maximum capital gains rate of 20%, while short-term profits are taxed at your ordinary income tax rate.
Spiegelman says this method is fairly complex and that it should be used only by individuals who have major long-term and short-term considerations--and who are really spreadsheet-oriented.