Sometimes, mutual fund investors are tempted to complicate things with issues that aren't related to investing. Taxes are a good example.
The best way to buy mutual funds, the investment guides say, is with a system known as "dollar cost averaging." An investor puts in the same amount of money, usually every month. When the fund's share price is low, that money buys more shares; when the share price is up, fewer shares are purchased, but the cheap shares bought earlier have become more valuable.
Is this the most tax-efficient way to buy mutual funds? After all, a system of monthly purchases means a stock or bond fund is being bought at 12 different prices during the year. And that means 12 different prices to use as the "cost basis." That's the price tax people use to describe what something is worth when it's acquired so it can be compared later to the selling price to figure out the gain or loss.
One way to avoid 12 different cost bases would be to buy mutual funds just once or twice a year, so that when fund shares are eventually sold, it would be easier to identify the ones to sell. Thus, if you had $10,000 in an equity fund, and needed to take out $1,000, you could ask the fund to sell $1,000 worth of those shares purchased at the highest price. You'd have your $1,000, but the taxable capital gain would be less.
However, that's putting the cart before the horse, tax specialists say. Any tax benefits that might come from making fewer purchases are more than outweighed by the potential investment losses of not using dollar cost averaging.
"Investment considerations should come first," says Andrea Markezin, a tax partner with Ernst & Young, accountants. "We tend to recommend dollar cost averaging. It's a disciplined savings program. If you're given a choice of putting in money every six months or every month, it's probably better to invest every month."
That way, she says, an investor is less likely to buy at the peak of the market, when share prices are high.
"It's really an investment decision, not a tax decision," agrees Joseph Palombo, director of tax practice at Coopers & Lybrand, another accounting firm. "There's no tax benefit" from waiting.
Taxes do come into play when it comes to selling fund shares, and for that, good records are required.
Many investors don't keep meticulous records of their mutual fund activity. Fund companies send out confirmation statements purchases and sales, but those statements can get lost, thrown out by mistake or misfiled. Then, when you want to sell some shares, you can'task for a specific group to be sold, and the fund is required to sell the first shares purchased. This is known as the first in-first out, or FIFO, rule.
However, if you keep good records, you can sell those shares bought at the highest prices. In fact, if the share price has fallen recently, you can get the money you need -- and declare a capital loss.
Many investors also forget about taxes when they're moving money from one fund to another in the same "family," Ms. Markezin says. "People tend to think that if they're in a Fidelity growth fund and they move to a Fidelity income fund, that there are no tax consequences." But unless the money is in a tax-sheltered account, like an individual retirement account, an exchange is just like a sale, and taxes have to be paid on any gain, she says.
Investors should keep an up-to-date list of the following: the date of each purchase, the number of shares purchased, the price of those shares, the date of all sales or exchanges from one fund to another, the number of shares sold or exchanged and their price, and the dollar amount of all transactions.
While you can build these records by keeping every confirmation statement received after a purchase or sale, when tax-filing season comes around you're usually safe in relying on the 1099-B statements sent by the fund at the end of the year.