The Tax consequences of buying and selling Shares in a mutual fund

Tax reporting on mutual funds can be complicated. At the end of the year, the mutual fund sends to each mutual fund shareholder a Form 1099 showing the amount of dividends and capital gains received during the year. Individual shareholders pay taxes on their dividends and capital gains. When you automatically reinvest your dividends and capital gains in your funds, these amounts need to be added into the cost basis when you sell shares in the fund. Suppose that you invested $10,000 in a fund two years ago and reinvested a total of $2,000 in dividends and capital gains in the fund to date. You then sell all shares in the fund and receive $14,000. Your cost basis is $12,000 (not $10,000), and the gain on the sale of the shares is $2,000 ($14,000 - $12,000).

When you sell only a portion of your total shares, the calculation is different and can be tricky. It is further complicated when you actively buy and sell shares as though the fund were a checking account. In fact, many mutual funds encourage you to operate your funds like a checking account by providing check-writing services. Every time you write a check against a bond or stock fund, a capital gain or loss tax consequence occurs. This does not include money market funds, which have a stable share price of $1. These actions can cause a nightmare at tax time and produce extra revenue for your accountant for the additional time spent calculating gains and losses. Consequently, you need to keep records of your mutual fund transactions by saving all the monthly statements showing purchases and sales of shares, dividends, and capital gain distributions. From these records you can determine the cost basis of shares sold using an average-cost method, the FIFO method, or the specific identification method.

The FIFO method (which stands for first in, first out) uses the cost of the first shares purchased in the fund as the first to be sold. Table 14–6 illustrates the FIFO method of calculating a capital gain or loss on the partial sale of shares in a mutual fund. The example shows that the earliest shares purchased are the first to be used in the sale of shares. After all the shares of the invested funds are sold, the basis of the dividend and capital gain shares is used to determine any gain or loss. During periods of rising share prices, using this method results in a higher tax liability than the average-cost method.

The average-cost method is an accounting method in which the average cost per share is determined by dividing the number of shares available into the total cost of the shares in the fund. Several funds provide the gains and losses on an average-cost basis when investors sell shares. The average-cost method allows shareholders to average the cost of the shares in the fund. The average-cost basis can get quite complex with additional sales and purchases of shares. Consequently, some funds don’t provide average-cost data after shareholders redeem shares in the fund.

The specific identification method allows shareholders to identify the specific shares that they want to sell. You can minimize your gains by choosing to sell shares with the highest cost basis first. However, to get Internal Revenue Service (IRS) acceptance of this method, you must specify to the fund in writing which shares are to be sold and must receive a written confirmation of the sale by the fund. If the specific shares are not identified, the IRS assumes that the shares sold are the first acquired.

Table 14-6
Calculation of Gains/Losses on the Sale of Shares


The specific identification method works as follows: Suppose that you buy 100 shares at $7 per share and six months later buy another 100 shares at $14 per share. You decide to sell 100 shares at $20 per share. If you specifically identify the shares bought at $14 per share, the capital gain is $6 per share ($20 - $14). Using the average-cost method, the cost basis is $10.50 per share ($2,100/200 shares), and the capital gain is $9.50 per share. Using FIFO, the shares sold are those purchased first at $7 per share, resulting in a gain of $13 per share.

If you use the average-cost method to sell shares in a fund, you cannot switch to the specific identification method for subsequent sales. This limitation does not preclude investor from choosing other methods to sell shares in any other funds that you own.

For individual stocks, investors cannot use the average-cost method, but specific identification and FIFO methods are acceptable. To minimize the complexities of computations, you are better off not writing checks on your stock or bond funds for your short-term cash needs. This practice only creates gains or losses. You are better served by investing the money needed for short-term purposes into a money market fund, which alleviates any complex tax calculations.

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