Mutual funds are like any other investment: sometimes you need to sell. Whether you are realizing a gain or getting out of a bad situation, a mutual-fund sale has big tax implications, regardless of what you do with the money afterwards. For some, the cut-and-run strategy may be best, while others may prefer a more gradual approach. Consider these tax rules as you make your decision.
Calculating Gain or Loss
When you sell your mutual-fund shares, you either make money -- a capital gain -- or lose money -- a loss. The value of the gain or loss is based on what you originally paid for the shares, known as your cost basis. Traditionally, the IRS uses the "last in, first out," or LIFO, method to calculated gain or loss -- you sell shares in the order you bought them. If you are like most mutual-fund investors, you may have purchased shares several times and reinvested dividends. You may have dozens of different cost bases, and adding them up is tedious. There are two options to avoid this: select the lots -- purchase groups -- you want to sell when you sell them, or use an average cost basis. The second method is typically the simplest: you add up all your cost basis and divide by the number of shares you hold. Don't forget to add in the cost of any broker commissions and SEC fees you paid, but leave out any mutual-fund company fee charged for your initial purchase or on the sale itself.
If you sell your shares for more than they cost, you have a gain, and this is taxable income. Gains come in two varieties: short term and long term. If you held your shares for less than 12 months, you have a short-term gain and it will be taxed at ordinary income rates. If you held it for 12 months or more, it is a long-term capital gain and is eligible for the capital-gains tax rate -- no more than 20 percent as of 2011.
If you have a loss, you can use this loss to offset any long-term capital gains you have during the year. As of 2011, investors are allowed to net up to $3,000 worth of capital loss against their gains each year. If you don't have a full $3,000 worth of gains, you can save the extra loss until next year. Note that you do not get a credit for capital losses that exceed the value of your capital gains. Both gains and losses are entered onto Schedule D of IRS Form 1040 when you file your annual taxes.
New Cost Basis
When you buy a new mutual fund, you have a new cost basis and new time clock for short- and long-term capital gains. Even if you perform a mutual-fund "exchange" by swapping one fund for the other in the same transaction, as is common in online accounts, you are still selling off an asset and buying something new.
Tax Implications of a Sell-Off
If you sell out of a mutual fund -- or any other investment -- you are responsible for any tax consequences of that sale in that same year. This is true no matter what you do with the money. While losses from a poor performer may reduce taxes through a capital-gain offset, capital gains may increase your tax burden, put you in a different tax bracket or even make you eligible for the Alternative Minimum Tax. Each of these consequences is highly dependent on your individual situation, so it may be valuable to talk things over with your accountant or financial advisor before making big changes.