Minimizing Taxes on Sales of Mutual Funds, Stocks

The House of Representatives’ version of the 2017 tax reform caused a panic among many tax
and financial advisors, because it would have effectively increased capital gains taxes on many investors, especially retired investors.

Fortunately, the change didn’t make it into the final law. Savvy investors retain some control over the amount of taxes they pay on sales of stocks and mutual funds from taxable accounts. The strategies are particularly important to retired investors. They often are selling a portion of their holdings each year instead of an entire position in a stock or mutual fund, and that’s where the rules change would have had its effect.

The capital gain or loss on the sale of an investment is determined by subtracting the cost of acquiring the asset(the basis in tax lingo) from the sale price (the amount realized). If you’re selling all of the position in an investment or acquired the investment in one purchase, there aren’t any strategies to
consider. Your basis is your total cost.

When you’re selling less than your entire position in a stock or mutual fund, however, there are different ways to calculate the basis. A different basis means a different gain or loss. The tax law gives you some choice in the methods for calculating the basis. The choices are:

• first-in, first-out (FIFO)
• average cost
• specific identification/actual cost

FIFO is the strategy that would have been mandated for all sales under the version of tax reform passed by the House of Representatives. This also is the default method for calculating the basis for stocks if neither you nor your broker chooses another method.

It probably is the easiest-to-use method, if you have all the paperwork, but it also can result in the highest taxes. The taxes likely will be higher under this method, because investment prices tend to increase over time. So, the basis of the shares purchased first is likely to be lower than the basis of
shares purchased later and also lower than the recent sale price.

The average cost method is the default method for computing the basis for mutual fund shares, and it
can be used only for mutual funds and dividend reinvestment plans.

The method is exactly what the name says. You add the total dollars invested in all the shares of a fund you own and divide that by the total number of shares held.

Average cost used to have a single-category and a double-category method, but the double-category
method was eliminated as of April 1, 2011.

Specific identification also is exactly what the name says. You decide which shares you sell. You might decide to sell the shares with the highest basis so your taxable gain this year will be minimized or the loss will be maximized. Or you might decide to sell shares with the lowest basis. This might be beneficial
when you have capital losses to offset the gains or will be in a lower tax bracket than usual because of deductions or reduced income.

You also can decide whether to sell shares that were held for one year or less (resulting in short-term gains or losses) or those held for more than one year (resulting in long-term capital gains or losses).

The specific identification method can result in optimum tax management, but it also can take a lot of work. You have to track which shares you sold each year, what their basis was, and what the basis is of the remaining shares. Some brokers have automated specific identification methods you can select to simplify this process. For example, on its website, Fidelity offers 12 methods investors can choose, such
as intraday FIFO; last in, first out; high cost; and low cost.

To use the specific share method, you have to contact the broker or mutual fund before selling the shares
and identify the shares you want to sell. The contact must be in writing, and most firms have a specified form or web page to make sure your request is clear. Contact the firm to learn how it needs to receive the written instructions. Also, you need to receive written confirmation from the firm of the
specific shares that were sold.

Example. Suppose Max Profits purchased shares of the Vanguard 500 Index fund twice a year for 20 years. The share price has gone from $97.62 to $259.62, with a lot of variation during that time. Max now is retiring and plans to sell some shares each year to fund his retirement.

Max could use the default average cost method, which we’ll say is $162 per share. That means Max will have a capital gain or loss on each share sold equal to the sale price minus $162. An alternative is to use FIFO under which Max sells first the shares purchased at $97.62. After those shares are sold,
Max sells the next shares purchased and so on. This would result in large capital gains early in Max’s retirement and perhaps lower gains as the years go on.

Finally, Max can use the actual cost/specific identification method. That gives Max more control over his tax bill each year. If the market declines, for example, he might sell the highest price shares so he has losses to deduct. When he has losses from other investments, he might sell the lowest price shares so the other losses offset those gains.

The method requires more work. Max has to track the basis so his tax returns are accurate. He also has to notify the broker in writing before each sale and receive confirmation of the shares sold.

Brokers and mutual fund firms are required to report to the IRS and investors on Form 1099-B the basis of investments sold each year. Many firms also report the basis in their year-end statements to investors. Basis has to be reported only for stocks purchased after 2010 and mutual funds purchased after 2011.

Remember, each broker and mutual fund firm establishes a default method for computing basis consistent with the IRS regulations. The firms told investors their default methods when the basis reporting rules first went into effect, and the firms gave investors the opportunity to elect a different method at that time. When new accounts are opened, investors are told the default method and given the opportunity to elect out of it.

With an existing account, you usually can elect out of the default method at any time.

When shares in a mutual fund were sold and the basis was computed using the average cost method, you can’t elect out of the average cost method for the rest of the shares held in that fund. But you can elect out of the average cost method as the default for other funds held in that account if you haven’t sold any shares.

You can elect to use the average cost method for mutual funds at any time. If you already sold some shares of that fund and used another method, you still can use the average cost method for future sales.

Under these rules, you can select different cost basis methods for different securities and different accounts.

Reducing the taxes on your investment gains is the surest way to increase after-tax returns. One way to do that is to manage the basis used to report the sales of stocks and mutual funds. You need to work with your fund firm or broker to determine the default basis method, your options for using a different method and how to choose another method. You might also want to work with a tax advisor to select the
best method to use. More details about the choices for computing the basis of investments sold are in free IRS Publication 550, Investment Income and Expenses. It is available free on the IRS website at www.irs.gov/pub/irs-pdf/p550.pdf.