How to Lower Your Mutual Fund Taxes

Two Magic Words

The magic two words when it comes to mutual fund taxes are "cost basis." Here's what we mean:

When you sell fund shares, your gain (or loss) is the difference between the sale price and an elusive figure known as your cost basis—essentially the price you paid for your shares, including any fees you paid when you bought them, plus any dividends and capital gains that you have reinvested in the fund.

Figuring your cost basis when you sell is probably the most complicated part about mutual fund taxes. If you sell all your fund shares at one time, your tax calculation is pretty straightforward, since your cost basis is simply the total amount you invested over the years.

But if you plan to unload only a portion of your shares, the tax code offers three ways to compute your cost basis, and only you can decide which is best for your situation:

1. "Average share price" method: When you use the average share price method, you figure your cost basis simply by dividing the total dollar amount of shares you own by the number of shares. For example, if you own a total of $10,000, and you own 500 shares, your cost basis is $20 a share.

2. "First in/first out" method: When you use the first in/first out method, it is assumed that the first shares you bought are the first shares you sold. Let's say you bought 100 shares at $20 a share, and then later bought 100 shares at $25 a share. Now you sell 100 shares. For tax purposes, it is assumed that the first 100 shares you bought are the ones you're selling now, so your cost basis is $20.

3. "Specific share" method: This third option lets you specify exactly which shares you are selling. Let's say you bought 100 shares at $20, 100 shares at $22, and 100 shares at $25. Now you want to sell 100 shares. You can designate—before the transaction takes place—exactly which shares you are selling. In effect, you choose your own cost basis. One note: It is very important that you clearly specify to your broker (we recommend putting it in writing) which shares you are selling before the sale. You cannot designate the shares after the sale.

You should talk with your accountant to see which option works best for you and gives you the best tax results. But here are a few things to keep in mind. Once you choose a method for calculating your cost basis, you must stick to it. No switching methods mid-course. Second, you must keep very good records if you want to use the first in/first out or the specific share method.

You might want to get your hands on a free copy of IRS Publication 564 (call 800-TAX-FORM or go to http://www.irs.gov/publications/p564/index.html). Believe it or not, this IRS booklet actually does a very good job of explaining these rules, complete with examples of how the rules work in different situations.

Mutual Fund links:

• 3 Ways to Earn Money Through Mutual Funds
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• Protect Your Money From Harm