Mutual Funds and Cost Basis Reporting

by Dale Bye

Beginning on Jan. 1, 2012, mutual fund companies will be required to provide cost basis reporting to the Internal Revenue Service each year for your mutual fund shares. Most mutual fund companies will use the average cost method in reporting your sales unless you specify otherwise. However, other tax basis methods might be more tax-efficient for you. Your mutual fund company will require you to change your cost basis method in writing. So, understanding the methods available and the rules that apply to each can save you money when you file your taxes.

Average Cost -- Single Category

Under the average cost method, your tax basis is the average cost of all the shares you've purchased in the fund. If you don't sell all the shares, the ones that are sold are considered to be the ones you've owned the longest. For example, if you bought 100 shares for $10 a share and got 4.45 more shares because of $52.17 of dividend and long-term capital gains reinvestment, your total investment would be $1,052.17 for 104.45 shares. That's an average cost of $10.073 per share for any that you sell.

Average Cost -- Double Category

Before April 1, 2011, the IRS allowed you to divide your shares into two pools: short-term for those held less than one year and long-term for those held more than a year. However, that tax basis method has been eliminated.

Average Cost Rules

Once you sell any shares using the average cost method, all shares bought before that sale date are locked into the average cost method. Shares bought after that sale may be sold using a different method. You may change at any time with all other methods of figuring cost basis.

First In, First Out

As the name implies, when you sell a portion of your shares using FIFO tax basis, the shares sold will be the ones you've held the longest. Typically, that means the shares you sell will be taxed at the lower long-term capital gains rate. You might also choose this method in a falling market, which means the shares you sell will have a higher tax basis, lowering or eliminating your tax liability.

Last In, First Out

Last in, first out is the opposite of FIFO. Although you may incur the higher short-term capital gains rate, in a rising market you would be selling shares with a higher tax basis, reducing your tax liability.

Low Cost, First Out

You might use low cost, first out if you're holding a large carryover capital gains loss, which would negate the added tax liability of choosing the least tax efficient method of selling your mutual fund shares.

High Cost, First Out

By choosing to first sell your highest cost shares, you will incur the least possible tax liability with each block of funds you sell. But in a rising market, you may be only postponing a significant tax bite.

Specific Identification Method

The IRS also allows you to choose blocks of shares to sell in any order you choose. You can even out your tax liability by selling your low cost shares in a falling market and the higher cost portion of your account when shares have appreciated. Specific identification is especially advantageous when you have made regular purchases in a long-term choppy market.

About the Author

Dale Bye has spent more than 40 years in journalism, including 25 supervising reporters and editors at metropolitan newspapers and eight years as senior managing editor at a national sports magazine. He directed five newspaper-sponsored personal finance fairs. His fields of expertise include business and personal finance, sports, fitness and theater. Bye holds a Bachelor of Journalism from the University of Missouri.