Mutual Funds at Tax Time
It is tax time and the questions are pouring in. How much of my profits do I have to give to the IRS? How much can I write off when it comes to my losses? To start, "ordinary income" includes all gains on securities held by you or your fund for less than one year and is taxed at your regular, marginal income tax rate. This rate can range up to 40%. Losses can be used to offset your gains and lower your tax bill.
If you sell your shares you have owned for more than one year, your profit is taxed at the capital gains rate of 20%. Reducing your turnover in your portfolio of funds could conceivably cut your tax bill in half. There is nothing you can do to avoid the capital gains distribution your fund hands out after the manager sells parts of his portfolio. Funds with low turnover are a test of patience but can be rewarding at tax time.
Automatic reinvestment of dividends results in the purchase of new shares, with a cost basis and holding period different from those of your original investment. The less often you sell, the less you will have to worry about such details.
Many people say they are "switching" or "exchanging" when they transfer money from one fund to another in the same family. This counts as a sale for tax purposes and you are responsible for any gains made in selling the first fund. This is a trade and only a trade and that is the way the IRS will look at it.
When you sell shares for less than you paid, you can deduct the loss fully against capital gains on other investments. A special restriction applies if you have a "net capital loss", or if your total loss exceeds your total gain. The amount of your ordinary income that can be offset each year by a net capital loss is limited to $3000 for joint and single filers or $1500 each for couples who file separately. You can carry forward any unused loss to the following year and longer if needed.
The Wash Rule
When you incur a loss and want to sell out and use the loss to offset gains, you must wait 31 days before buying back in, or the IRS will reject the deduction. You cannot get around this by buying new shares in the fund before you sell your initial position. The wash rule extends 30 days before your sale also.
Calculating how much you made or loss with fund sales
The first-in, first-out method assumes you sold shares in the same order you bought them. Most of the time you do not want to use this method of calculation as it almost always favors the IRS.
Specific Share Identification
This method will let you pick the shares to redeem. This method also needs a lot of attention because you have to keep all records of any purchase of fund shares and this would include automatic reinvestments. When you sell, you must obtain written confirmation from the fund showing the number of shares redeemed and their purchase date and purchase price. This method is only for the person who can keep good records, doesn’t mind paperwork and pays attention to detail.
Average-cost per share Method
This is by far the easiest method to use and requires that you lump all your shares together and divide the total amount you paid for them by the total number of shares. Many funds will do this for you. Remember that you can't use this method to figure your gain on sales of individual stocks.
Picking from one of the above methods for calculating how much you made or lost is important and you should take the time or get advice on which method will keep more money in your pocket. Don't let the IRS pick a method for you or you can bet it will result in more money for them and less for you.