Filling out your tax return is like compiling the index of a book -- the book is complete, but you have to rummage (sometimes painfully) through your work again, assuring accuracy and factual content, in order to make the book easier for someone else to read. If you're a mutual fund investor trying to determine your taxable gain or loss for the past year, your tax return will entail additional work.
But if you've kept good records and understand some basic guidelines, the process can be relatively painless.
The first step in evaluating your tax liability is knowing which investment transactions require payment of taxes. In general, whenever you sell or exchange shares of a mutual fund, you may have a capital gain or loss that must be reported in the tax year of the transaction. In addition, most funds receive periodic dividend or interest income from stock or bond investments and incur capital gains or losses when selling securities in the fund during the year. The fund company passes these dividends, interest, and capital gains to you, the shareholder, either in a check or through reinvested distributions. You must pay taxes on dividends, interest, and capital gains that the fund company distributes to you, in addition to capital gains on sale or exchange of shares in your account. Reinvesting distributions in more shares of the fund does not relieve you from having to pay taxes on those distributions.
The next step is understanding the difference between short- and long-term capital gains. Short-term capital gains (assets held 12 months or less) are taxed at your regular income tax rate, whereas long-term capital gains (assets held for more than 12 months) are currently subject to federal tax at a rate of up to 20%.1 Remember that each dollar of capital loss can offset a dollar of capital gain. In other words, if you have $1,000 in long-term gains and $600 in long-term losses, you only have to pay tax on a net long-term gain of $400. Should your losses exceed your gains, you can offset up to $3,000 of excess capital losses against ordinary income. Losses beyond $3,000 can be carried over and deducted from income in future years.
In order to determine whether you have a gain or loss on a sale or exchange, you must first know your "adjusted cost basis." That's because you will be taxed on the difference between the cost basis of the fund shares and the amount you received when you sold them.
Under a new federal law that took effect on January 1, 2011, financial institutions are now required to report cost basis for certain investments to investors, on Form 1099-B, which typically is made available to investors in January of the following year. The expanded Form 1099-B specifies whether a gain or loss was short term or long term. The new cost-basis reporting requirements took effect for certain securities in 2011, and apply to mutual fund shares purchased on or after January 1, 2012.
Previously, when an investor sold a position in a security or a fund, the investor's financial firm was required to report only the gross sale proceeds to the investor and to the Internal Revenue Service (IRS). It was typically up to the investor to track the cost basis and to calculate the capital gain or loss, and the resulting tax liability, for income tax purposes. The IRS always gave you the choice of one of four accounting methods to determine cost basis in a way that could benefit you most.
FIFO, which stands for "first in, first out," means the shares you bought first are also the ones you sell first.
The specific identification method of selling shares demands more planning on your part, but also provides the most flexibility of any method for determining the amount of gain or loss on your shares. For example, if you want to select certain shares to sell in order to produce the best tax benefit for your situation, you have to specify the shares you want to sell in advance and in writing to your fund company. Then, you'll receive confirmation of your request for your tax records. Therefore, if you've sold shares of a fund in the past year, and didn't specify which shares, it's too late to use this method for that particular fund. You can, however, use specific identification in the future, as long as you haven't previously employed the single- or double-category average cost method.
The single-category average cost method calculates your cost basis by simply averaging the purchase price of all your shares, regardless of how long you have held them. This method is particularly time-saving if you are redeeming or exchanging all shares of a fund account and have invested over many years and reinvested your dividends. But the tax result may not be advantageous if you're only redeeming a portion of the account.
Double-category averaging provides more flexibility in this latter scenario. With this method, you separate your holdings into two categories -- shares held for more than a year and shares held for a year or less. Your cost basis is then based on the average of the category from which you wish to sell shares. For instance, if you want to sell shares at the 15% or 20% top long-term capital gains tax rate rather than at your higher ordinary income tax rate, you'd average the cost of the shares you've held for more than one year and only sell shares that are long-term holdings. On the other hand, if you need to sell shorter-term holdings, your cost basis would be the average cost of those shares that you've owned for one year or less. Like the specific identification method, double-category averaging provides you with more flexibility, but requires more work because you must request in writing that the fund company sells shares that have been held more than one year or for one year or less.
Most financial institutions use average cost as the default tax lot identification method for mutual funds, but you should check before making this assumption. Note that you may still select the cost basis reporting method you prefer.
Keep in mind that you can't change to another method at a future date without permission from the IRS once you've chosen single- or double-category averaging for a particular fund. Also, you must specifically state on your return if you are using one of the averaging methods. These restrictions are not placed on shareholders using either the FIFO or specific identification method of selling shares.
If you buy shares of a fund that has a front-end load, the sales charge is included in the cost basis of those shares. Therefore, if you send your fund company $1,000 to purchase shares that have a 5% load up front, your account would be worth $950. However, your cost basis would still be $1,000 for tax purposes. If your fund company charges a load when you sell your shares, the load should be deducted from your gain or added to your loss. For example, if you invested $1,000 in a fund and sold those shares later for $2,000 with a 2% back-end load, your gain on those shares would be $1,000 minus the load of $40 (2% of $2,000), or $960.
Also note that when you purchase additional shares as a result of reinvesting dividends and capital gains, such shares are included in your cost basis. And if you're thinking about taking losses this year in order to offset other gains, keep in mind that you cannot sell shares at a loss and buy additional shares in the same or substantially identical mutual fund within 30 days before or after the date of sale. The applicable federal tax law treats that as a "wash sale."
There's no substitute for keeping careful records of all mutual fund investments. Especially important are year-end statements, which generally list the past year's transactions, including dividends and capital gains distributions. If you're missing records for any year, ask your fund company to supply them. They'll be indispensable when preparing your tax return in future years when you sell those shares.
The above guidelines can provide you with some sense of direction as you plan to compile your "index" of taxable transactions from the past year. Of course, you may want to consult a tax advisor regarding your particular situation to ensure that you are making the decisions that are best for you. It can never hurt to have someone "edit" the masterpiece you've created.
1An additional 3.8% Medicare contribution tax may also apply to certain capital gains.
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