Mutual fund shareholders got a big boost to their bottom lines this year when the top tax rates on long-term capital gains and on dividends were reduced to 15%. Fund investors can get further tax reductions by carefully planning and reporting sales of fund shares. Here are steps to consider before year end.
Don’t always take losses. The usual rule is to sell shares of losing funds that aren’t long-term holdings. Use the losses to reduce income taxes, and reinvest the proceeds into more productive investments. You’ll generate more after-tax wealth.
It is a good general rule. Yet, there is an exception, inspired by tax accounting rules. The law says that when you have capital losses, these first offset any capital gains for the year. Up to $3,000 of excess losses can be deducted against other types of income. Any additional losses can be carried forward to future years.
A long-term capital gain is taxed at a maximum 15%, while ordinary income is taxed at up to 35%. If you already have long-term capital gains to report for the year, you might want to defer taking losses until next year. The losses are more valuable if they offset ordinary income instead of long-term gains. Use losses to offset short-term gains and non-tax advantaged income if you can. If you have long-term gains every year, go ahead and take the losses and shelter the gains. But if long-term gains are not an annual event, you are better off taking losses when they will offset ordinary income instead of long-term gains.
Don’t forget reinvestments. Many fund shareholders have distributions automatically reinvested in more fund shares. When that happens in a taxable account, the distribution is included in income for the year. The reinvested amount increases your tax basis in the fund investment. When you sell, this higher basis either decreases your taxable gains or increases your deductible losses.
Shareholders often forget to add these reinvestments to their basis when reporting fund sales. As a result, they pay higher taxes than they are required to. That’s why it is important to keep all your fund statements showing distributions and reinvestments. Most fund companies can produce copies of past statements, but they might charge fees and take weeks or months to get the statements. Some of the larger fund companies now regularly provide calculations of share basis on annual statements.
Best way to report sales. When less than a full position in a mutual fund is sold, the tax law gives you four choices for computing your basis and reporting the sale. The different methods could result in very different gains if you accumulated the shares over time at different prices.
The specific identification method lets you decide which specific shares are sold. If you want to minimize gains or maximize reported losses, you can identify the shares having the highest cost as the ones to be sold. To maximize gains (for example, if you have sizeable capital losses for the year), identify the shares with the lowest cost. Identifying specific shares also lets you decide whether the shares sold have a long-term or short-term holding period.
To specifically identify the shares sold you must be able to adequately identify the shares that were sold. This means notifying the broker in advance of the particular shares to be sold. You also need to get confirmation in writing that those were the shares sold.
The first-in, first-out method (or FIFO) assumes you sell shares in the order in which they were acquired. It is the easiest method to use but often results in the highest taxes.
The other two methods are averaging methods.
The single category method is a simple average. You total the basis of all shares in the account and divide that by the number of shares in the account. That average is your basis for all shares sold from that account this year. The holding period, for determining whether the sale is of a long-term or short-term asset, is determined using the first-in, first-out method. The first shares bought are the first ones sold for holding period purposes.
The double category method is a little different. All shares in the account are divided into long-term and short-term holdings. (Short-term shares are those that were owned for one year or less.) Determine the total basis for the shares in each category and divide that by the number of shares in each category. That gives you the basis for the shares in each category.
Then, you can specify whether you are selling shares from the long-term or short-term category. This has to be confirmed in writing by the custodian to be valid. If you do not specify or get a valid confirmation, then shares from the long-term category are assumed to be the first sold.
Different methods can be used for different funds. To use the single- or double-category method, an election must be made on the first tax return for which you want the method to apply. The election applies to all shares in that particular fund until all the shares are sold, unless IRS permission is obtained to change it. The requirement to use the same averaging method for all shares in a fund applies even if you own shares of the fund in different accounts. If you haven’t used a single- or double-category method, then you can choose each year whether to use the specific identification or FIFO method.
The single-category method probably is the easiest to use and understand and requires the least recordkeeping. Double-category and specific identification methods give taxpayers the most control but require the most work in both computations and recordkeeping.
The mutual fund companies that calculate the basis in your shares on regular statements almost all use one of the averaging methods. That can make either of these methods the easiest to use if the fund company is automatically computing the basis for you.
The specific identification method might be the most difficult to use. Many brokers, especially online brokers will not allow you to specify which shares were sold or are not set up to provide the written confirmation. Most mutual fund companies say that they can provide these services. Therefore, your broker or mutual fund company might eliminate some of your options.
The method that is best for you is determined by when you bought the shares, the prices paid, and how many of the shares you are selling. It might also depend on your other tax factors for the year. For example, if you already have capital losses for the year, it can be beneficial to take some short-term capital gains. Otherwise, you might prefer to have tax-favored long-term capital gains for the year.
The specific identification method when available offers the most control. The double-category method provides the next level of control and flexibility, because you can decide whether you are selling long-term or short-term shares. The FIFO and single category methods offer little control. The only way to decide which method is best is to compute the results under the different methods before the shares are sold.