Minimizing tax damage in fund sales

Your Funds

December 05, 2004|By CHARLES JAFFE

DAN B. in Lowell, Mass., isn't thinking of making an investment this holiday season. Instead, he's looking at dumping a few mutual funds to pay off some sudden bills he has incurred.

So when I warned last week about the prospect of late-in-the-year investments incurring unwanted tax bills, Dan wanted to know if there was a way to "minimize the tax damage" he's about to incur.

It's a good question this time of year because investors may have a lot to gain by rebalancing their portfolios before January, taking the tax benefits of losses and postponing gains as long as possible.

Ideally, most people would take losses now and hold gains off until January and next year's tax bill. But Dan - and probably many others - just can't wait.

With that in mind, tax-saving moves must be planned well in advance for any fund you intend to sell. It's mostly a matter of knowing the rules and having adequate records.

The sale of mutual fund shares in a taxable account generates a capital gain or loss - the difference between what you paid for the shares and what you got when they were sold.

These gains or losses are subject to taxes, even if your action merely involved swapping shares in one fund for a stake in another fund run by the same company.

(Capital gains are not a concern in tax-advantaged investments such as retirement and pension plans and individual retirement accounts. In those situations, however, early-withdrawal penalties can be a big problem.)

The key number for investors to know is the amount paid for a fund - including the price of shares purchased through dividend reinvestment, regular monthly deposits or occasional additional investments.

Sell all of your shares at once and your cost equals the average price you paid for the shares. Many fund firms now provide this calculation for you at the bottom of your statement.

Of course, if you sell everything you have in a fund there is only one taxing concern: How much money did you make or lose compared with what you put in.

If there is a loss, you can use it to offset other capital gains or up to $3,000 in ordinary income per year until the total loss is exhausted.

But if you only sell a portion of your stake in a fund, you have options for handling the sale that can limit your gains and make the most of your losses.

Technically, the choice boils down to which shares you sell, a ridiculous concept because your shares aren't paper purchases but rather a ledger entry in an electronic bookkeeping system. You'll need good records - don't be shy about requesting duplicate statements.

Here are your tax options for selling a stake in a fund:

Average cost basis

The easiest method for disposing of shares is average cost basis, but it's not usually the most tax-friendly.

What's more, once you sell shares in a fund based on average cost, you're stuck with average cost for all future sales.

FIFO

"First-in, first-out" is precisely what it sounds like; you are selling the first shares you bought. Examine the cost of your initial purchase; if the fund has gained ground since then, you actually maximize your tax bill by unloading a fund this way. Ooops.

Specific identification

Assuming the fund gained ground, look at the price paid for all purchases and consider the "specific identification method."

Pick shares for which you paid the most money and sell them first, thereby minimizing your gains.

Alternatives

There is also a method for selling a stake in your fund called "average cost, double category," but it is both confusing and highly unlikely to yield the best results - not to mention far too complicated to be explained here.

Let's look at how some numbers play out: You bought 100 shares of the XYZ Fund at $15 in 2000, at $17.50 in 2002 and at $20 last year. Today, the price remains $20 and you want to sell 100 shares.

You paid $5,250 for 300 shares. The average cost per share was $17.50, so average cost basis results in a taxable gain of $2.50 per share.

Using "first-in, first-out," you sell the $15 shares and have a gain of $5 per share.

And if you notify the fund firm that you are selling the highest-priced shares, purchased for the same $20 the fund is worth today, you have no capital gain.

But to sell specific shares, you must notify your fund company in writing. Phone redemptions won't cut it.

Without the letter - which is necessary to convince the IRS that you did it right - you can't take the tax savings later. Keep a copy of your letter and ask for a written confirmation.

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