Minimizing the Tax Bite When You Sell Shares

You can always tell when spring’s approaching by the number of tax statements piling up in your mailbox. Mutual fund companies, for example, will mail you a Form 1099-B, typically in late January, if you’ve redeemed shares during the previous year or switched from one fund to another.

Before you let the topic of mutual fund taxation lull you to sleep, consider this: When you sell shares, the Internal Revenue Service gives you three basic ways to calculate your capital gains and losses, and the size of your tax bill depends on the choice you make. What’s more, you could wind up paying Uncle Sam twice on the same gain in different years if you’re not careful.

“There is a tendency to overpay taxes (on mutual funds), because many people are not savvy enough to keep good records,” says Ed Rosenson, a tax partner in the Century City office of Ernst & Young, the accounting firm.

The main danger: You pay taxes on reinvested income and capital gains this year, but forget to increase your cost basis to reflect the transactions when you sell shares in subsequent years. The higher your basis, the better off you are from a tax standpoint.

This topic baffles many people. Fidelity Investments reports that mutual fund owners’ most frequently asked tax question is how to compute the cost basis on shares sold.

Naturally, you don’t have to worry about the tax impact of your mutual fund transactions on funds you hold in an individual retirement account or other tax-sheltered plans. Nor should you fret about money market funds, which don’t produce capital gains or losses because they are managed to maintain a constant price (usually $1 a share).

But all other stock and bond portfolios are fair game. That includes municipal bond funds, for which you might have a taxable gain or loss even though the interest you receive is tax-exempt.

Before you sell shares held in an unsheltered account, decide which of the three main methods to use, because once you have elected a tax-calculating approach, you must stick with it on that fund. However, you’re free to choose different methods for other funds you own.

If you don’t make a selection, the IRS assumes you’re using the FIFO (first in, first out) method. Unfortunately, this approach can result in a higher current tax bill on a fund that has steadily appreciated over the years.

Suppose you made three $1,000 investments in a fund, first buying 50 shares at $20 a share, then 40 shares at $25, followed by 30 shares at $33.33 apiece. Further imagine that you got a $275 dividend reinvestment along the way at $27.50 a share and that you want to sell 40 shares at a current price of $35.

Under FIFO, for tax purposes, the shares you sell would be the ones you purchased first--at $20 each. Since these shares have the lowest cost basis, $800, you would face a rather large capital gain of $600 (see chart for details).

A second approach, known as the average cost method, would result in a lower capital gain and tax liability. To calculate the average cost, you merely compute your total investments and reinvestments and divide by the number of shares owned.

In the above example, each share--including the 40 that you sell--would carry an average cost of $25.19 ($3,275 divided by 130 shares). On a 40-share redemption, the cost basis would be $1,008 and the resulting capital gain $392.

“If you’ve been accumulating shares over the long term in a fund that’s been going up, average cost will give you the better tax results,” says Rosenson. The average cost, he adds, is also relatively easy to compute, especially when you must include all those little capital gains and dividend reinvestments.

Some fund companies, such as Putnam and Oppenheimer, recently have come out with statements that calculate the average cost for you.

(It’s worth noting that a variant approach allows you to calculate a separate average cost for both your long-term and short-term fund holdings. However, in years when gains are taxed at the same rate regardless of holding period, such as 1990, this variant method is of little significance.)

The third main method, known as specific identification, offers the most tax-reducing opportunities, but it’s also the trickiest to use. Simply put, you tell the fund company which shares you’re selling at the time of the transaction. That means you can redeem your highest-priced shares first--regardless of when purchased--thereby reducing any capital gain or bloating any loss. This strategy makes sense if the price of the fund has fluctuated dramatically.

In the above example, you could choose to sell all 30 shares purchased at $33.33 each, plus 10 of those reinvested at $27.50. Of the three main methods, this results in the highest basis ($1,275) and the lowest capital gain ($125).

Bruce Grenke, a principal at Asset Allocation Advisors in Walnut Creek, Calif., likes the idea but cautions investors to think ahead. “You must identify these shares at the time you’re placing the sell order, preferably in a letter of redemption,” he says.

You’re not allowed to wait until tax preparation time, several months later. Your letter should specify which shares you’re selling by the date you bought them and the price you paid. Be sure to make a copy for your records.

The specific-identification method can make sense for elderly fund investors, Rosenson says. If these people opt to sell their most expensive shares first, they can reduce or eliminate current taxes. When they pass away, the big potential tax liability on the remaining, lower-cost shares would vanish, he explains, because the investment would get a “step-up” in basis to the current market price.

Naturally, you will want to keep good records of your mutual fund transactions, because that simplifies the tax-calculation process and lowers the danger that you might overpay later.

Grenke tells of a client who last year sold a stake in the Pioneer Fund for $125,000 after making a single $6,500 purchase in 1965. The investor had been paying taxes on reinvested capital gains and dividends for years, each time boosting his cost basis. He kept all the related paperwork.

By the time of sale, the man’s basis had increased to $110,000, meaning that he owed taxes on a gain of just $15,000. “Had he not kept good records, he might have paid more taxes than he needed to,” Grenke says. “The ultimate responsibility rests with the individual. Even a broker won’t necessarily keep records for 25 years.”

If you should lose some important mutual fund statements, you can always contact the fund company, which will supply the missing paperwork, either free or for a modest charge. But this takes time and can prove costly, especially if you must enlist your accountant’s help to reconstruct your financial past.

TAXES: THE CHOICE IS YOURS

When you sell shares in a mutual fund, you must figure the resulting cost basis. The IRS lets you pick any of three main methods (FIFO, average cost or specific identification) to make this calculation, which gives you some control over the size of your current tax bill when you make a partial redemption. Here’s how you would treat a $1,400 redemption under each of these three main methods.

Price/ Shares Date Transaction Share Bought (Sold) 6/1/89 Invest $1,000 $20.00 50 10/1/89 Invest $1,000 $25.00 40 12/15/89 Reinvest capital gain $275 $27.50 10 2/1/90 Invest $1,000 $33.33 30 4/1/90 Sell $1,400 $35.00 (40)

FIFO: The 40 shares sold would be those purchased first, at $20 each. The cost basis would be $800, and the taxable gain would be $600 ($1,400-$800).

Average cost: All shares would carry an average cost of $25.19 ($3,275 divided by 130). The cost basis on a sale of 40 shares would be $1,008, and the taxable gain would be $392.

Specific identification: You would sell your 40 highest priced shares--30 of those bought at $33.33 each and 10 at $27.50. The cost basis would be $1,275, and the taxable gain $125.