The Ins and Outs of Mutual Fund Taxation

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Tax Time Calculating the tax due from the sale of mutual fund shares does nothing to heighten the enjoyment that comes with tax-time. As a matter of fact, as popular as they have become as an investment vehicle, mutual funds can be downright scary at that time of the year.

Help is on the way. Section 403 of the Energy Improvement and Extension Act of 2008 amended the Internal Revenue Code to mandate that every security custodian report a customer’s adjusted basis in the security and whether any gain or loss on the sale is classified as short-term or long-term. This rule became effective for common stocks on January 1, 2011. The effective date for mutual funds is January 1, 2012.

The Act provides that when a custodian transfers securities to another custodian, the transferring custodian must furnish to the receiving custodian a written statement with all necessary information required for the receiving custodian to comply with the Act’s basis reporting requirements. Once this information is captured, the documentation will transfer along with the investment.

The downside to the Act is that it only applies to transactions going forward from January 1, 2012. You will need to provide your custodian with cost information on your existing positions. However, once the information is captured, you won’t have to update it ever again.

Mutual funds generate tax liabilities three ways for investors. First, if the fund collects interest (non tax-exempt) or dividends they must pass through the realized interest and dividends to the shareholders at least once a year. These are taxed at ordinary income tax rates.

Second, if the fund buys and sells securities during the year, the fund creates short and long term capital gains or losses. Again, these must be passed through yearly to shareholders.

In these two cases, even if the fund shareholder elects to use the distributions to buy additional shares, the distributions are still taxable. For cost purposes, the reinvested shares are new purchases and add to the total cost basis of the position.

Finally, if the shareholder sells shares, and a gain or loss is realized by selling for more or less than the cost basis, the shareholder may have either short-term, if the shares sold were held for less than 12 months, or long term gains or losses. Now for the scary part…it is possible to purchase a mutual fund one-day, and get hit for a big tax bill the next, if the fund has realized significant tax gains during the year and not done anything to offset the gains with losses.

For example, suppose an investor buys a fund that invests in small companies. If the fund manager holds these stocks for several years, allowing the companies to grow, at some point he will sell the stocks, since the companies have outgrown the investment objectives of a small company fund. When this occurs, whoever owns the fund at the time of year the fund makes its taxable distribution gets stuck with the reported tax gain.

Therefore, an investor could buy one day and shortly thereafter get hit with a large taxable gain. To add insult to injury, even if the value of the investment falls due to lower share prices, the gain from the distribution is still taxable.

If you sold shares during the year, you will need to determine your gain or loss by subtracting your cost basis from the sales proceeds. The IRS allows three methods for determining the cost basis—First In, First Out (FIFO), Average Cost, and Specific Identification. The Average Cost method, which is the most commonly used, requires you to determine the average cost per share—total dollars invested divided by the total number of shares held.

The Average Cost approach has two variations: double-category and single- category. With the former method, you divide your shares into two groups: those held longer than one year (long-term shares) and those held one year or less (short-term shares). Then, figure the average cost per share for each group. With the single-category method, you figure the average cost per share for all shares held in the account, and any shares that are sold are considered to be those held longest in the account.

Regardless of which method you choose, you need to keep copies of your year-end statements or confirmations to accurately calculate your cost basis.

Rick’s Insights

  • Provide your custodian with cost information on existing mutual fund positions so all positions have complete cost information going forward.
  • Choose your cost basis method and report it to your custodian. Follow up to verify they are reporting properly.
  • Be very careful when buying mutual funds in a taxable account at year end to avoid buying a fund prior to dividend distributions.

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