You might be wondering, “Goodness — mutual funds buy and sell shares of stock each day. Do I have to account for each of these transactions?” The answer is no, you don’t.
But you do have to account for the shares of the mutual fund that you sold during the year. And if you’re like many people who regularly buy shares of various funds each month, and you have your dividends reinvested in additional shares, the accounting can begin to seem impossibly complicated. It isn’t, though — as long as you’ve kept good records of when and how you got each share.
Calculating cost basis
The taxable gain or loss when you sell funds is the difference between the amount you receive from the sale and the cost basis of the shares you sold.
The first thing to calculate for the shares sold is their cost basis. This will depend on how you received them. If you purchased them, your cost basis is the purchase price. If you got the shares as part of a dividend reinvestment plan, the cost basis is their price at the time of purchase.
If you inherited the shares, the cost basis is usually their fair market value (the “net asset value”) on the date of death of the decedent. If the shares were given to you as a gift, things get a bit complicated. IRS publications 564 and 550 have detailed information about calculating the cost basis of shares you receive as a gift.
Once you have the initial cost basis for the shares, you’ll need to continue to add the cost of additional shares purchased to that basis. If you received a dividend that was reinvested back into additional shares in the fund, you should increase your basis by the amount of the dividend, thereby incorporating the value of the dividend in your basis.
Many people believe that reinvested mutual fund dividends are simply taxable income and don’t see them as a purchase of additional shares. Not so.
Look at it this way: The mutual fund company gives you a dividend check. And then you turn right around and buy more mutual fund shares with that check. You are buying additional shares — you’re just bypassing the extra paperwork of receiving the dividend check and sending the mutual fund company a different check to pay for the purchase. And you’re buying those shares at different times and at different prices. So record-keeping is crucial when dealing with mutual funds.
Identifying shares sold
When accounting for mutual fund shares sold, you have more choices than you have with individual securities. With individual stock, you’re stuck with either the First In, First Out (FIFO) method or the Specific Shares method. With mutual fund shares, you can use either of these two methods, or you can average the cost of the shares.
With the Specific Shares method, you keep records of acquiring each share of a mutual fund, and you clearly specify which ones you’re selling when placing the order, just as with stock.
The FIFO method means that the shares sold were the first ones you owned. So if you accumulated 337 shares over many years and sell 50 shares, you’ll subtract the adjusted basis for the first 50 shares you owned from the sale price in order to determine your gain or loss. The disadvantage is that this method can maximize your gain, as your earliest shares are likely to have the lowest cost basis. The upside is that because you’ve held them the longest, these shares are most likely to qualify for the lower long-term tax rate.
Your third option is averaging the cost of all your shares. That might sound simple, but again, you have a choice of two ways to do it: the Single Category method and the Multiple Category method.
With the Single Category method, you add up the purchase prices of all your shares and divide by the total. For example, say you started with 100 shares of the ABC Fund purchased for $50 each. Later, you bought 100 more shares at $60 each. Over time, your dividends are reinvested and you get a notice that you have five more shares purchased at $52 each. You then average them as follows:
- 100 shares at $50 = $5,000
- 100 shares at $60 = $6,000
- 5 shares at $52 = $260
- 205 shares = $11,260.
$11,260 divided by 205 equals a cost basis of $54.93 per share.
So if at some point you sell 50 shares for $65 each, you calculate your gain using a cost basis of $54.93. You record your gains or losses on Schedule D. This cost basis will remain in effect until you acquire more shares. Then you’ll have to recalculate.
Note also that you still have to pay attention to holding periods. Whenever you sell any share, you’ll have to figure out its holding period (a year or less, or more than a year) and its appropriate tax rate. But no matter what the holding period and tax rate, with the Single Category method, the cost basis is the same.
Next up is the Multiple Category method. This is very similar to the Single Category method, but you average the shares in subsets according to holding period. It gets more complicated when you sell off shares over time. You’ll have to recalculate, incorporating new shares acquired in the interim and recategorizing all the shares as their holding periods change.
The Multiple Category method is a little more work, but it often decreases the taxes you pay. To use it, you make all the calculations whenever you sell shares. Here’s an example of what your results might look like:
Short-term shares (held a year or less):
- 200 shares at $40 = $8,000 (bought in April)
- 100 shares at $30 = $3,000 (bought in May)
- 5 shares at $32 = $160 (bought in June)
- 305 shares = $11,160; average cost basis is $36.59 per share.
Long-term shares (held more than a year):
- 200 shares at $28 = $5,600 (bought last April)
- 200 shares = $5,600; average cost basis is $28 per share.
With this method, when selling shares, you use the cost basis that corresponds to the holding period of the shares you’re selling. So if you were selling shares you’d held for 14 months, your cost basis would be $28 per share.
Time marches on
Shares in your short-term category will become long-term holdings as long as they remain in your portfolio.
Most mutual fund companies will provide cost basis information for you when you sell your shares — averaged according to the Single Category method. That’s nice of them to do, and it might take a lot of pressure off you at tax time when you’re reporting your mutual fund sales.
But you should also remember: If you transfer mutual fund shares from one broker to another, the cost basis information could be lost. And there are still mutual fund companies out there that don’t provide you with cost basis information on shares sold, so you had better know how you stand with your broker or mutual fund company as to the computation of your cost basis for tax purposes.
If they don’t do it for you, you’re forced to do it yourself. And even if they do provide that information, you don’t have to have to use the method chosen for you by the mutual fund company. You can use the method that best suits your needs and tax planning.
One other caveat
Whatever method you select, you’re stuck with that method for that specific fund for as long as you’re invested in that fund. In our example above with the ABC Fund, the Single Category average cost method was used. That’s an election that was made, and that same method must be used for as long as you own the ABC Fund. But there is nothing in the law that prevents you from using a different method if you’re invested in the XYZ Fund, even if both of those funds are in the same fund “family.”
While we’re on the subject: Something not every investor realizes is that even tax-exempt mutual funds can leave you with taxable gains or losses. Most of the income produced from the fund might be tax-exempt, but the fund can produce some taxable income (perhaps if it sells bonds at a taxable gain) and the shares themselves remain taxable assets at the time of sale.
Many of these issues are complicated, but you should be familiar with them if you decide to invest in mutual funds.