Mutual Funds and Capital Gains
Calculating Capital Gains on Mutual Fund Shares
Tax Planning: U.S. Ads
Mutual Funds and Capital Gains
You will need to calculate capital gains on each share of the fund you are selling. If you have invested in a fund over a period of time, then you will have different cost basis for your initial investment, additional investments, and any purchases made through reinvested dividends. Each investment has its own cost basis and its own holding period.Capital Gains Distributions
Mutual funds often sell profitable investments at certain times throughout the year. The funds then distribute the profits to shareholders in the form of a capital gain distribution. Capital gains distributions are reported on Form 1099-DIV, which shows dividends and capital gains distributions paid throughout the year. Capital gains distributions are taxed at long-term capital gains tax rates, no matter how long you have personally owned shares in the mutual fund. Capital gain distributions can be reported directly on Form 1040 if you have no other capital gains to report. Otherwise, capital gain distributions are reported on Schedule D along with your other gains and losses.Capital Gains When Selling Mutual Fund Shares
You will calculate your capital gain or loss for every mutual fund share you are selling. If you have invested in a fund over a period of time, you will have a different cost basis and different holding period for each share you own. The IRS allows you to use four different accounting methods for calculating your gain. You can use the method which is most advantageous to you. However, once you choose your accounting method for a particular mutual fund, you must stick with that method. You can choose different accounting methods for each mutual fund you own. The four allowable accounting methods are:- Actual cost basis using specific identification,
- Actual cost basis using first-in, first-out identification,
- Average cost basis, single-category method, and
- Average cost basis, double-category method
Specific Identification of Mutual Fund Cost Basis
The specific identification method of accounting is the preferred method for savvy investors. You will need to keep track of each lot of shares you buy and sell. Moreover, your broker must allow you to sell specific shares. This option is usually provided with a mutual fund company's cost basis tracking service.Specific identification enables the investor to choose which shares to sell for the greatest possible tax benefit. An investor may want to sell the most profitable shares to offset other losses, or may want to sell the least profitable shares to minimize the capital gains tax.First-In, First-Out Method of Identification
Even if the shareholder cannot specific particular shares to sell, the actual cost basis method can still be used. You keep track of your cost basis for every lot of shares you buy. When calculating your gain, you assume that the first shares sold are the first shares you bought.Average Cost Basis, Single Category Method
You calculate your average cost basis based on the price paid for each share you bought, including any reinvested dividends and reinvested capital gains. The average cost basis is the total purchase price of all shares divided by the number of shares owned. When you sale some shares, it is assumed the shares are sold on a first-in, first-out basis. Your capital gain is calculated using the holding period of the oldest shares being sold, even if you are selling a mixture of long-term and short-term shares.Average Cost Basis, Double Category Method
You calculate your average cost basis based on the price paid for each lot of shares you bought, including any reinvested dividends and reinvested capital gains. However, you must separate your shares into long-term and short-term investments, and then calculate average cost basis for each category of shares. The average cost basis is the total purchase price of all shares of the same category divided by the number of shares owned in that category. When you sale some shares, it is assumed the shares are sold on a first-in, first-out basis.Reinvested Dividends and Capital Gains Distributions
Many investors re-invest dividends and capital gains distributions received from their mutual funds. Each reinvestment is both a cash distribution and an additional fund purchase. The dividends and capital gains distributions are included taxable income. The additional shares purchased in the reinvestment have their own cost basis (the purchase price of the shares) and their own holding period.Tracking Mutual Fund Cost Basis
Tracking your cost basis can be a time-consuming task. I highly recommend using Quicken or Microsoft Money to keep track of your capital gains.IRS Information
IRS Publication 564, Mutual Fund Distributions, contains in-depth information about the tax aspects of investing in mutual funds.---------------------------------------------------------------------------
Figuring Cost Basis When Reporting Sale of Stocks
By William Perez,
Every year I get tons of brokerage statements from clients, and I need to prepare an accurate calculation of their gain or loss on a Schedule D. Here's some reminders about the information you need for computing your capital gains.First, please bring your brokerage statements from when you bought the stock. This is very important, and not every brokerage firm will keep track of this information for you.
Second, accountants cannot make up numbers for you. It's up to you to search through your records to find your investment information.
Third, a gentle reminder on how to calculate your gain or loss. The formula is Selling Price minus Cost Basis. And the formula for Cost Basis is purchase price (cost per share times number of shares) plus purchase costs (commissions) plus selling costs (commissions).
If you are preparing your taxes, or just need some extra time to make sure you have received all your tax documents, then file an extension today. Filing an extension takes about five minutes of your time, but you get an extra four months to finishup your tax return
Comments
- September 3, 2008 at 1:26 pm(1) Tay says:
- Thank-you very much for this. So if I bought at different times at different prices, then I add all of those up as my cost basis if I sold everything or is it share-to-share? And if I didn’t sell off the entire position, which price do I use since the stock was bought on different date/prices?
- September 3, 2008 at 7:47 pm(2) taxes says:
- You can take a look at the methods for figuring cost basis in a mutual fund for an overview of the different methods used to calculate your cost basis. For stocks, the difference is that we use either the specific identification method (which I prefer). If that’s not possible, then we use the first-in, first-out method. For more detailed information, see Publication 550, chapter 4.
- November 11, 2008 at 3:57 pm(3) Erica says:
- I inherited stock in ‘88 and made mistakes every year since ‘00 after my divorce. My broker cannot do cost basis because they didn’t track it. How would I find out?
- November 17, 2008 at 4:13 pm(4) William Perez says:
- Erica, your cost basis in the stock is the value of that stock on the day that the person from whom you inherited the stock died. Any dividends that were reinvested will increase your basis. There are historical stock price databases, especially at Yahoo Finance and at Big Charts.
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Mutual Fund Capital Gains Distributions
When Gains Are Not Good
From Lee McGowan, former About.com Guide
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Did you ever dream you might get taxed on shares of Microsoft that were purchased at the IPO? You didn’t buy shares of Microsoft at the IPO, you say? Maybe not, but if you own a mutual fund that purchased the stock at the IPO and they sell it while you own shares of the fund, you might be on the hook for paying tax on a portion of the gain.
These capital gains distributions are the result of the fund selling shares, such as with the Microsoft IPO as described above. If the fund manager decides to sell a stock due to the changing outlook for the stock, or even if the fund must simply raise cash for shareholder redemptions (if a shareholder sells shares of the fund), if the stock is trading higher than when the fund initially purchased it, the fund must distribute at least 95% of the gains to shareholders.
The capital gains distribution is taxable to the fund shareholders unless the fund is owned in a tax-deferred account (IRA, 401k, etc.).
For example, let's say XYZ Mutual Fund purchased 100,000 shares of a stock 20 years ago for $1. The fund sells the 100,000 shares today for $50, which results in a long-term capital gain of $49 per share. The fund must distribute the gains to current shareholders and the shareholders must report the gain on their tax return.
For instance, looking further at the XYZ Mutual Fund distribution:
As previously mentioned, these capital gains distributions result in a tax bill if you own mutual funds in a taxable account. Retirement plans (IRAs, 401ks, etc.) are not impacted by capital gains distributions. Keep in mind, the reinvestment of the gains is added to your cost basis -- reducing your taxable gain when the fund is eventually sold.
If you own mutual funds in a taxable account you may want to focus on low-turnover funds, which include index funds and tax-efficient mutual funds (even some actively managed funds have low turnover). Otherwise, you should consider visiting your fund company’s website beginning in October of each year to determine if and when there will be capital gains distributions.
If the distributions are anticipated to be large, you should weigh the advantages and disadvantages of owning the fund. Indeed, you may want to sell the fund in order to avoid the distribution. If you sell the fund to avoid the distribution, be aware that if you buy the fund back within 30 days (either in your taxable account or in your IRA), you will run afoul of IRS wash sales rules.
Mutual Fund Distributions
Each year, generally in the last couple of months of the year, mutual fund shareholders face the possibility of receiving capital gains distributions from their mutual funds. Don’t be fooled by the capital gains distributions. These are not gains of the good sort.These capital gains distributions are the result of the fund selling shares, such as with the Microsoft IPO as described above. If the fund manager decides to sell a stock due to the changing outlook for the stock, or even if the fund must simply raise cash for shareholder redemptions (if a shareholder sells shares of the fund), if the stock is trading higher than when the fund initially purchased it, the fund must distribute at least 95% of the gains to shareholders.
The capital gains distribution is taxable to the fund shareholders unless the fund is owned in a tax-deferred account (IRA, 401k, etc.).
For example, let's say XYZ Mutual Fund purchased 100,000 shares of a stock 20 years ago for $1. The fund sells the 100,000 shares today for $50, which results in a long-term capital gain of $49 per share. The fund must distribute the gains to current shareholders and the shareholders must report the gain on their tax return.
What Is the Economic Value of the Distribution?
While it might seem like a positive to receive a capital gains distribution, there is actually no positive economic value to the distribution.For instance, looking further at the XYZ Mutual Fund distribution:
- You own 1,000 shares of the XYZ Mutual Fund. The fund has a net asset value (NAV) of $10 per share. Your investment in the fund equals $10,000.
- The total value of your holding in the fund is $10,000 (1,000 shares at $10 per share) and you reinvest all capital gains and dividends.
- The fund distributes long-term capital gains as described in the previous example. The long-term capital gain upon the sale of stock in the previous example is 10% of the fund’s total net asset value or $1 per share.
- Shareholders of record on the record date will receive $1 for each share they own and the NAV of the fund will be reduced by $1 on the ex-dividend date.
- As a result, you receive $1,000, which is automatically reinvested in the fund.
- Assuming no change in the market value, you still own $10,000 of the fund.
As previously mentioned, these capital gains distributions result in a tax bill if you own mutual funds in a taxable account. Retirement plans (IRAs, 401ks, etc.) are not impacted by capital gains distributions. Keep in mind, the reinvestment of the gains is added to your cost basis -- reducing your taxable gain when the fund is eventually sold.
If you own mutual funds in a taxable account you may want to focus on low-turnover funds, which include index funds and tax-efficient mutual funds (even some actively managed funds have low turnover). Otherwise, you should consider visiting your fund company’s website beginning in October of each year to determine if and when there will be capital gains distributions.
If the distributions are anticipated to be large, you should weigh the advantages and disadvantages of owning the fund. Indeed, you may want to sell the fund in order to avoid the distribution. If you sell the fund to avoid the distribution, be aware that if you buy the fund back within 30 days (either in your taxable account or in your IRA), you will run afoul of IRS wash sales rules.
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