Your Taxes : Mutual Fund Rules Befuddle Even Savvy
Former bank depositors who switched to mutual fund investments this year probably think they’re smart. After all, funds posted another year of double-digit returns, while yields on certificates of deposit languished.
But now that tax time is here, these investors may be singing a different tune. Even the savviest individual can be befuddled by mutual fund taxation.
There are three different ways to determine mutual fund gains or losses.
Funds generate six different types of income.
And if you buy international funds, you may be entitled to special deductions or credits. But if you don’t know about these arcane foreign tax credits, you might just think your fund company made a reporting error.
“The complexity is unbelievable,” says Gregg Ritchie, a partner in the personal financial planning group at KPMG Peat Marwick in Los Angeles. One seemingly simple mutual fund investment is enough to send investors screaming for a tax accountant--particularly if they sold a few shares during the year.
When you sell shares either by writing a check against a mutual fund account, transferring money from one fund to another or simply by redeeming shares, you’ve got to grapple with arguably the most difficult fund tax issue: your so-called cost basis.
What makes cost basis so difficult and how can you make sense of it all? Here’s a question-and-answer guide.
Q What is cost basis?
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A It’s a fancy term for how much you paid for your shares. That’s something you have to figure out whenever you sell shares, so you know whether you have a taxable gain or a deductible loss.
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Q Isn’t the cost of my shares obvious? Why would it be difficult to arrive at my cost basis?
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A For two reasons. First, the typical mutual fund investor invests relatively small amounts regularly, often through automatic investment programs. Many also reinvest dividends. The result is that an average fund investor may ring up more than a dozen “purchases”--probably all at different prices--in just one year.
Second, the investors are given a choice of three methods to determine their cost. The results from each can differ significantly.
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Q What are the three methods to determine the cost of mutual fund shares?
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A You can use the “first-in, first-out” method, which assumes that the first shares you sell are the first ones you bought. You can use 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 the average cost. Or you can use the “specific shares” method, which lets you choose which shares you’re selling, as long as you do so at the time of sale.
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Q What’s the difference? Can’t I just arbitrarily pick one?
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A You could. But you might be missing out on a good tax-planning opportunity if you do, experts say.
Consider an investor who buys 250 mutual fund shares each quarter. The shares he bought in the first quarter cost $6 each. In the second quarter, they cost $7; they were $10 in the third quarter and $8 in the fourth. Altogether, he spent $7,750 for 1,000 shares--an average of $7.75 each.
In December, he sold 100 shares for $8 each.
If he uses the average cost method, he has a gain equal to 25 cents per share, or $25. If he uses the first-in, first-out method, he would have a $200 gain (the $8 sales price minus the $6 first-quarter purchase price).
If he uses the specific shares method, he could choose to sell the $10 shares, leaving him with a $2 per share--$200--capital loss. *
Q So how do you pick the best method?
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A By considering your total tax picture, including whether you have other investment gains or losses that could be offset by profits or losses in your mutual fund. If you had other capital gains, you might choose the specific shares method so you could offset them with your $200 capital loss. If you had a capital loss elsewhere in your portfolio, you might want to use the first-in, first-out method, which would generate the biggest gain.
But if mutual funds are your main investment, you may want to use the average cost method simply because it’s the easiest. Many mutual fund companies calculate it for you and disclose it on your annual account statement.
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Q What are the drawbacks to particular methods?
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A If you use the specific shares method, you must send the fund company a dated, written request to sell or exchange the shares, stating how many you’re selling, the date they were purchased and the purchase price. You must 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 would fare better by using another method. By sending the letter, you’ve locked yourself in to the specific shares method, at least for this transaction.
Meanwhile, if you select the average cost method, you must continue to use it for as long as you hold that fund’s shares. If you later want to change to another method, you’ll have to get approval from the IRS. And the IRS doesn’t give such approvals freely, says Michael A. Klein, a tax partner at Fidelity Investments in Boston.
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Q How do I account for reinvested dividends?
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A The amount reinvested would increase your cost basis in the fund. Say you paid $1,000 for your shares, and the fund reinvested some $500 worth of dividends for you. Later, you sold your shares for $2,000. Your taxable gain is $500, which is $2,000 minus the original $1,000 purchase price and the $500 in reinvested dividends.
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Q I haven’t pulled any money out of my mutual funds, but I have transferred some between accounts. From the statement I received, it looks like that’s considered a sale. Is that right?
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A Yes. You sold one investment and bought another. You have to determine your gain on the sale. And you must start keeping track of your cost in the new fund.
If you write a check against a mutual fund account, you’re also selling shares, Ritchie notes. Some new fund investors forget that because it “feels” the same as a bank withdrawal, which doesn’t trigger tax.
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Q How do I account for sales charges?
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A Generally, they’re automatically deducted from your fund returns, so you don’t need to keep track of them. If for some reason they’re not, factor them in. But be sure to keep good records in case you’re audited.
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Q What about the rules on types of income? Why should interest earnings and capital gains be re-characterized as dividends simply because they are from a fund?
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A It has to do with who is doing the investing. You--and millions of people like you--invest in mutual funds. The mutual funds take your money and use it to invest in stocks or bonds or other securities.
The value of your mutual fund investment rises and falls depending on whether the value of securities the fund has purchased rises or falls and whether the fund’s investments pay interest or dividends. However, technically you own a share of the fund company, not the underlying investments. Consequently, the fund company may earn interest or capital gains. But when it pays you earnings, it is paying dividends on your investment in the fund.
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Q If that’s the case, why does the fund company pass on long-term capital gains?
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A Because the U.S. tax code makes no sense at all. This is one of the many areas where a fairly logical rule has several exceptions, and the treatment of a fund’s long-term capital gains is one of them. Any gain the fund earns on an investment held more than a year can be passed through to you as a long-term capital gain. It doesn’t matter how long you held your investment in the fund. If the fund says you’ve got a long-term gain, you do.
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Q What kinds of income can I earn by investing in a mutual fund?
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A Technically, six. Taxable dividends, short-term capital gains, long-term capital gains, federally taxable dividends, state-taxable dividends and tax-free dividends.
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Q What difference does it make what kind of income I earn? Income is income, right?
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A That’s true for everything except taxes. Dividends are taxed at ordinary income tax rates, which now go as high as 39.6%. Long-term capital gains are taxed at a maximum rate of 28%. Short-term capital gains are taxed at ordinary income rates, but they can be offset by capital losses. In the end, what kind of income you earn could cost you--or save you--thousands of dollars in federal tax.
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Q How, then, would I have a short-term capital gain from a mutual fund investment?
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A If you profit from selling mutual fund shares that you’ve held less than a year, you’ll report a short-term capital gain. But any short-term capital gains that the fund earns will be passed through to you as dividends.
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Q You said before that some dividends become tax credits. What does that mean?
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A If you invest in an international fund, the fund company may have paid foreign taxes on your behalf. If it did, you can take a credit for those taxes on your U.S. tax return, says Klein, the Fidelity Investments tax manager in Boston.
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Q How would you know if that happened?
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A Usually you’ll notice it because your annual fund statement looks messed up, Klein notes. Let’s say that your international stock fund, which is more than 50% invested in foreign securities, paid you $70 in dividends during the year. But when you got the annual statement, it said the fund paid $100. A separate line said “foreign tax paid--$30.”
What that means is that you actually earned $100, but the fund company paid $30 in foreign taxes on your behalf. You can take a tax credit for that $30, if you fill out a foreign tax credit--Form 1116--and file it with your return. Or you can simply deduct the amount as an itemized deduction under “other taxes paid.”
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Q Isn’t a tax credit better than a tax deduction?
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A Normally, yes. Tax credits reduce your tax dollar-for-dollar. Tax deductions reduce your taxable income, which also reduces your tax, but by a smaller amount.
However, in the case of the foreign tax credit, it can be so difficult to fill out the form that you could save money by just taking the deduction. That’s because Form 1116 requires you to delineate your “foreign source income” versus your “non-foreign source income” and then complete a complicated calculation to determine whether your tax credit should be limited--a time-consuming and frustrating process. “It’s kind of ugly,” says Klein. One foreign tax credit can double the size of your return because of all the extra calculations that you--or your accountant--has to do, adds Ritchie of KPMG Peat Marwick in Los Angeles.
In other words, unless you’ve got a substantial foreign tax credit, it’s easier--and, if you’re getting your taxes professionally prepared, more cost effective--to simply deduct.
Tax Forms Are Free
Publishers of myriad tax books say one of their main selling points is that they provide consumers with “ready-to-use” and “IRS-approved” tax forms. In other words, these books, which sell for between $10 and $15, include extra copies of the 1040 and other necessary tax schedules.
Apparently, some taxpayers don’t realize that the forms are free. At tax time, most public libraries put out hundreds of commonly used forms, the IRS says. Some post offices have them too. You can also call (800) TAX-FORM. The IRS will send them to you.
