Figuring Taxable Gain on Mutual Funds
When you buy or sell stocks and bonds, it’s pretty simple to determine whether you have a taxable profit or a loss. But that’s not always true if you’re buying and selling stock and bond mutual funds.
Indeed, if you subscribe to a popular practice among mutual fund investors called dollar-cost averaging, figuring your gain or loss--especially when selling only a portion of your holdings--can take hours, says Philip J. Holthouse, partner at the Los Angeles tax firm of Holthouse Carlin & Van Trigt.
“It truly is hard to do it right,” adds Harvey Gettleson, partner with the Big Six accounting firm of Ernst & Young. “It’s very tricky.”
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Here’s a question-and-answer look at how you can make sense of “cost basis” in a mutual fund:
Q: What is “cost basis”?
A: It’s the total amount you paid for your shares, including sales charges, commissions and reinvested dividends, and excluding any principal that’s been returned to you.
Q: Why is that difficult to figure out?
A: Many investors buy mutual funds over time through a process called dollar-cost averaging. In essence, they invest a set amount--say $100 each month. But since fund prices can vary, their $100 may buy 10 shares one month and 12 shares the next. If they later sell part of their holdings, they must use one of three methods to figure how much they paid.
Q: What are the three methods?
A: The first is called FIFO, for first-in, first-out. It assumes the first shares you sell are the first ones you bought. The second, called “specific shares,” lets you choose which shares you’re selling, as long as you do it contemporaneously. At the time of sale, you would have to detail in writing whether you were selling the shares you bought in January or July, for example. The third is called the “average cost” method, which allows you to add up all the money you’ve spent on a specific fund’s shares and divide by the number of shares you own to determine an average cost.
Q: Why are there so many methods?
A: Oddly enough, it’s because Congress wanted to encourage people to invest. These choices, while complicating tax filing, allow you to better manage your taxable gains and losses and therefore minimize your tax bill.
Q: What’s the best method to use?
A: There isn’t a simple answer. The average-cost method is usually the most simple, particularly if you invest with a handful of fund companies that will figure the average cost for you. But the specific-shares method may help you better manage your capital gains and losses.
Q: How so?
A: The best way to illustrate is with an example. Let’s say you bought 1,000 shares of XYZ fund throughout the year. The cost was $6 in March, $8 in June, $7 in September and $10 in December. For example’s sake, we’ll say your average cost was $8. Now you decide to sell 100 shares at $8. Do you have a gain, loss or neither?
If you use FIFO, you would have a gain of $2 per share, or $200. If you use average-cost, you would have neither a gain nor a loss. If you used specific-shares and said you were selling the December shares, you would have a $2-per-share, or $200, loss. You need to consider your total tax picture to determine which method would work out best for you.
Q: Are there any drawbacks to choosing a particular method?
A: A few. If you use the specific-shares method, you must send the fund company a dated, written request to sell or exchange the shares. You have to say how many shares you’re selling, the date they were purchased and the purchase price. And you should keep a copy of the request for your tax records.
The problem arises if you realize later that, for tax-minimization purposes, you’ve sold the wrong shares or it would be to your benefit to use another method. By sending that letter, you’ve locked yourself into the specific-shares method for this one transaction.
Additionally, if you select average-cost, you must continue to use that method as long as you hold that fund’s shares, says Keith Lawson, associate counsel for tax at the Investment Company Institute in Washington. If you later want to change to another method, you must get approval from the IRS, and the IRS rarely gives such approvals, Gettleson said.
Q: How do I account for reinvested dividends?
A: The amount reinvested would increase your basis in the mutual fund. Say you paid $1,000 for your shares, but the fund reinvested $500 in dividends over the years. Later, you sold your shares for $2,000. Your taxable gain is $500, which is $2,000 minus the original $1,000 purchase price plus the $500 in reinvested dividends.
Q: What about “loads” and redemption fees?
A: Loads, which are up-front sales charges, and redemption fees, which are back-end sales charges, should also be added to the cost of the fund to determine your full purchase price.
