WISE UP ABOUT TAXES ON YOUR MUTUAL FUNDS

You can save a bunch of money by paying attention to the tax implications of your mutual fund decisions. Here are the two big issues every investor should consider.

Let’s assume you’re a savvy investor and when you buy a mutual fund, you use Web sites like this one to investigate a specific fund’s investment performance, its expense ratio, its Morningstar “star” rating, the manager’s investment strategy and other issues.

But do you think about the tax implications? Taxes shouldn’t dominate your investment decisions, but to ignore them would be foolish and clearly would affect your returns.

At the end of January, your mutual fund company will send you a 1099 form showing your portion of the fund’s dividends, interest, short-term and long-term gains. You report those gains (better known as profits) on your 1040, Schedule B (dividends and interest) and Schedule D (short- and long-term capital gains) and pay tax at your own individual marginal rate.

There are two big issues affecting mutual funds, which we’ll go through in more detail below:

The date of record

The cost basis

Date of Record

Do you know the date of record for your various mutual funds? If you don’t — or if you’re like most people and don’t even know what the date of record is — it could cost you big at tax time and in the overall performance of your investment portfolio.

To understand the importance of date of record, you have to understand the nature of the mutual fund as an investment vehicle. A mutual fund is nothing more than a company that takes money from various investors and purchases securities. Depending on the objective of the fund, those securities can be stocks, bonds, options, etc. By pooling everyone’s money, we get a diversified holding of securities designed to lower risk while giving a solid return. It’s a glorified investors’ club in which you’re paying the fund to manage your money.

The problem is that when you invest in a mutual fund, you’re buying into an ongoing portfolio of securities, many of which were bought years ago. If the fund manager has been successful, these securities are pregnant with potential capital gains.

In addition, prior to your buying in, that portfolio manager may have sold securities, potentially creating either a long- or short-term gain.

Because a mutual fund is a flow-through entity, it isn’t taxed on its gains. Rather, the investors in the fund are taxed directly on their proportionate share of the fund’s gain.

That’s why date of record is so important. That’s the day the fund will look at its record of owners and allocate to them all of the gains and losses from that year’s operations. If you bought into the fund December 1 and the date of record is December 15, you are going to be taxed on your share of the fund’s full-year gains, even though you held the fund for just two weeks. (If the fund is in a tax-deferred account like a 401(k), 403(b) or IRA, the tax implication doesn't apply.)

Almost as painful is the fact that when you bought your shares in the fund, you paid a price that probably reflected the fund’s appreciated value already. In other words, you bought and paid for the gain and now the IRS wants you to pay tax on that gain, even though you personally didn’t get any of the profit. It’s almost a guaranteed “lose” situation.

How do you avoid this hidden trap? The easy answer is never to invest in a mutual fund right before the date of record. Note that if you buy on the date of record, you won’t be subject to this hit — it takes some time between your purchase and the actual recording of your name in the mutual fund’s books. But computer efficiency is shrinking this time period significantly. In any case, know your fund’s date of record and don't get caught by it.

Alternatively, you can invest in an index fund. These are funds that invest in an index (the Standard and Poor’s 500 or the Dow Jones 30, for example) and, therefore, don’t have a lot of turnover. The lower the turnover, the less gain recognized and passed through to you.

Don’t necessarily avoid, but at least be aware of funds with assets that already have incurred significant appreciation. For example, a fund that has substantial investments in Time Warner, Dell Computer, or MSN Money publisher Microsoft that were bought at long-ago prices would have an incredible past earning record. However, if and when that fund’s manager decides to sell any of those high fliers, the owners of that fund are going to be hit with an enormous capital gain and a hefty tax bill. They’re tax time bombs waiting to explode.

Cost Basis

A mutual fund’s cost basis is the original price the fund manager paid for the individual stocks and other securities held in the fund. When the manager then sells some of those holdings, the manager has to notify the IRS of the capital gains accrued from the sale. (If it’s sold at a loss, it’s reported as a capital loss, which actually helps at tax time, even if it doesn’t help your investment portfolio’s return.)

There are two levels of taxation with respect to mutual funds.

The first level is the inside gain. It’s the flow-through of the gains actually incurred and recognized to the fund. Let’s say you bought $1,000 in a fund a year ago that’s now worth $1,100. You have an inside gain of $100.

The second level is the outside gain. That is the difference between what we sell the shares for and what our cost has become.

For instance: If you have elected to have any gains in your funds reinvested rather than distributed to you, then those gains are added to your cost basis. So, if you bought 100 shares of a mutual fund for $1,000 ($10 per share) and then recognized $200 in gains (the form of the gain and whether it is long term or short term are irrelevant), both the cost basis and the number of shares are increased. The basis is easy — it’s now $1,200. The cost basis per share, however, depends on the number of shares that $200 bought.

If the fund had doubled in value, then the $200 would have bought only 10 shares ($200 divided by $20). Your cost basis per share would then be $1,200 divided by 110 shares or $10.91. Alternatively, had the fund decreased in value to $5 per share when you reinvested the $200, that would have bought you 40 new shares. Your basis per share would then be $1,200 divided by 1,040 shares or $8.57 per share.

Most people forget or neglect to add their inside gains to their basis, which reduces their capital gains and thus reduces their taxes. It requires you to keep track of each year’s reported inside gains and, unfortunately, many people either fail to keep the appropriate records or just don’t know the rules.

This is really important when you sell the shares: You don’t want to be taxed twice on the same gain. Even if you haven’t kept your records, your mutual fund can supply you with the data you need.

Another issue you have to consider is how you manage a fund in which you sell some of the shares, but not all of them. If you’ve bought shares over a period of time at different prices, the tax implications can be huge. Here, you have three options:

1.

Specific share identification. Here, you ask your broker or the fund to sell specific shares purchased on specific dates. The cost of those specific shares becomes your basis for gain or loss. You may want to use this formula if you want to sell funds that haven’t performed up to expectations and you’re looking for a graceful exit strategy that has the side effect of lowering your capital-gains tax.

 

2.

First in, first out (FIFO). Under this method, you assume the first shares bought are the first shares sold. In a rising market, this gives you the greatest gain (or highest tax bill).

 

3.

Average basis. This option, in turn, has two sub-options within it:

You can use the single category accounting method, in which you take your total cost plus reinvested gains and divide that by the total number of shares held for an average cost basis per share. Then, multiply that number by the number of shares sold.

Alternatively, you can select the double category method, in which you separate short-term holdings (purchased less than 12 months ago) from your long-term holdings (purchased more than 12 months ago) and compute an average cost per share for each. You must then tell your broker or the fund from which category you are selling.

Whenever you use the double category method, you should get a letter from your broker or fund company that confirms which shares were sold. Moreover, you can use different methods for different funds you own.

Each method allows you to select those shares you are selling and, by doing so, allows you to either increase or decrease your profits — and thus, your taxes. The higher the basis, the smaller the gain, and the smaller the tax you’ll have to pay on that gain.

What you would be left with are the shares with the lowest basis (or cost), and by definition, the highest potential gain (or profit) on sale. But those shares will be sold later (or stepped up in basis to fair market value at your death which means no tax will ever be paid on that gain). Do the calculations and pay the least the law demands from you now.

Deciding which is the best option for you requires working with a tax specialist, your broker or a little time with a spreadsheet. It might be a little more work, but it could save you a lot in taxes.