Capital gains on mutual funds
Due to all the uncertainty in Washington, I am seriously considering selling my entire mutual fund portfolio for fear of a major stock market adjustment to the downside. The funds were purchased decades ago and all my dividends were reinvested over the years. How do I calculate my tax basis and capital gains?
Mutual funds have become one of the more popular vehicles for stock market investments. Mutual funds generally purchase an inventory of different stocks and are controlled by experienced investment managers. The funds, like the individual stocks they purchase, are subject to share price (value) fluctuation. Therefore, buying shares of a mutual fund allows the investor to, in effect, purchase numerous stocks while utilizing the expertise of the fund investment manager.
As with the sale of an individual stock, to calculate the gain on the proposed sale of your funds, you must first calculate your tax basis or cost of the fund shares.
If you sold your entire fund interest, then your tax basis is simply the combination of your cash purchases plus all the dividends reinvested back into the funds. The dividends you reinvested are treated the same as if you had received a cash distribution from the fund, and then decided to write a check back to the fund to purchase additional fund shares. Lastly, you will need to compare your selling price to your calculated tax basis to arrive at your capital gain.
Please note that gains from shares held over one year will receive the more favorable long-term capital gain tax treatment. Gains from shares held for less than a year will be treated as short-term capital gains, subject to ordinary income tax rates.
If you sold only a portion of the shares held in a mutual fund, you may have to pick between one of four methods to determine your basis of the shares redeemed. A choice is necessary only if you purchased shares in the fund at different times. The following four methods are available to you:
1. First-in, First-out (FIFO) Method: With the FIFO method, the assumption is that the first shares you purchased are the shares you sell first.
2. Specific-Identification Method: The use of the specific-identification method allows you to identify the specific shares sold. This is allowed only if a mutual fund will redeem shares according to this method. Additionally, you must submit a written notice to the mutual fund company in advance of the share redemption. This notice must provide the fund company with the specific shares to be redeemed and the purchase price per share. It is advisable to retain a copy of this notice in the event of an IRS audit. In the event you fail to follow these procedures, the IRS can force you to use the FIFO method.
3. Average-Cost Method: Under this method, you can calculate your pershare basis by using the average cost per share. To arrive at your average per-share cost, simply total your entire investment, including dividends invested, and divide that number by the total number of shares owned.
4. Average-Cost-Double Category Method:
This method requires you to classify your mutual shares as either short-term or long-term. An average is computed for each category. You may then choose shares from either category in determining the basis of fund shares sold.
Before using the average-cost method, you should be aware that if this method is used, it must be used for all accounts for the mutual fund on which it is used. However, any method can be used for other mutual fund accounts you sell. Also, you are required to state on your tax return, or in a statement attached to your tax return, that the average-cost method was used.
Before you spend time calculating your cost basis, I recommend that you first contact your broker or mutual fund company to determine if they have the information you require.