The cost basis basics of mutual funds

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In the investment world, taxes are the price you pay for success. And sometimes that success — and accompanying tax bill — come as a total surprise.

That’s the predicament mutual fund shareholders may find themselves in when the books are closed on a turbulent market. Fund managers sell assets throughout the year, passing along a portion of any gain from those sales to the individual shareholders as capital gains distributions. That means the shareholders owe the Internal Revenue Service even though their fund’s overall value may have dropped in a chaotic market.

Similarly, savvy investors who picked a hot stock and cashed in on it also will have to share a portion of their new money with Uncle Sam.

But there is a silver lining for long-term investors. While they can’t avoid taxes on stock gains, those who buckle into the market roller coaster for an extended ride will find their patience can offer them a lower tax bill.

Special tax rates for some gains
Since stock investments aren’t guaranteed moneymakers, tax lawmakers decided to reward the risk-taking. Capital gains receive more favorable tax treatment than regular income, like wages or interest earned on bank accounts. Depending on your tax bracket and on how long you hold an asset before selling it, you could pay substantially less on capital gains money than you would pay on the same amount received as salary.

Regular income is divided over six tax brackets, with the 2003 rates ranging from 5 percent to 35 percent. Even though tax law changes will fractionally cut those rates more in coming years, most investment-holding taxpayers still will get bigger breaks by paying at capital gains rates.

Capital gains from stocks that are held more than a year are taxed at a maximum 15 percent rate, thanks to law changes enacted in May 2003. And the rate is just 5 percent if your total income is in the 15 percent bracket.

But this is the government, so there’s a catch: The lower capital gains tax rate applies to long-term capital gains. This means you must hold your investments for more than a year before selling. If you sell earlier, any gain is classified as short-term and is taxed at the regular income rates.

Remember, the cut-off is more than a year. If you sell on the 365 th day, any gain is short-term. So when you’re contemplating selling, keep an eye on the calendar. If you determine you can wait to sell without hurting your holdings’ overall value, then do so. But don’t ever hold onto a stock that you think might nosedive just to avoid paying short-term capital gains taxes.

When you do cash in that hot stock, for either a long- or short-term gain, you pay for your success by filing a Schedule D along with Form 1040.

Losing timing control
While the date-of-sale rules are critical in determining whether you’ll owe the lower long-term capital gains tax, sometimes the timing choice is not yours. This is the case for mutual funds.

With an individual stock, you decide when you buy and sell, giving you some control over the stock’s tax implications. But with mutual funds, some assets are sold throughout the year and a portion of any gain is then passed along to you, the shareholder, as a capital gains distribution. For most funds, the largest distribution to fund holders comes at the end of the year. It doesn’t matter whether you get a check for these distributions or re-invest them in the fund; they still are taxable.

The IRS considers capital gain distributions as long-term and gives them more favorable tax treatment, but that doesn’t totally ease the pain when the taxable amount is unexpectedly large. Such was the case for many investors during the bull markets of a few years ago. One shareholder, for example, found that his mutual fund portfolio then produced distributions totaling more than $25,000.

The good news: He bragged about his fund-picking prowess. The bad news: He had to pay taxes on the unexpected windfall. While paying the lower long-term capital gains rate was certainly better than forking over a chunk of the earnings at the regular income clip, it still caused a substantial dent in the old wallet.

Fund moves are tax sales
And don’t overlook the tax consequences of re-allocating your mutual fund holdings. Some investors are shocked to discover that when they move accounts from one fund to another, even within the same fund family, the IRS considers this selling.

If there’s a gain associated with this fund shift, it’s taxable at either the short- or long-term rates (or a combination of both) depending on when you bought the first fund shares.

So pay attention to your funds and all your portfolio management actions throughout the year. This will give you time to prepare for or ease any impending tax burden.

More importantly, it could help prevent any penalties that might come from not paying enough taxes in payroll withholding contributions. To avoid a tax underpayment penalty caused by capital gains — either via stock sales or fund distributions — you might want to adjust your salary withholding or make estimated tax payments when you see the value of your portfolio increasing.

Investing tax strategies
Other than more accurately forecasting what your ultimate capital gains tax bill might be, is there anything the average investor can do to ameliorate a capital gains tax burden?

The easiest move is maximizing tax-deferred investments. Taxes aren’t due on IRA or 401(k) plan distributions for years — or, in the case of Roth IRAs, ever.

If you’ve maxed out your retirement accounts and have some taxable stock holdings, Mark Mayad, a principal with Concorde Investment Management in Dallas, suggests timing your sales over an extended period. This will spread the gains, and their taxes, across future tax years.

As for mutual funds, Towson University accounting professor Seth Hammer advises his clients, who include members of the NFL’s Baltimore Ravens, to look at index funds, which have a low turnover ratio. Turnover ratio, Hammer explains, is how often the fund trades its investments. More trades mean more opportunities for capital gain distributions to be passed along to the fund holder.

Richard Bregman, president of MJB Asset Management in Manhattan, acknowledges that in the end, there’s “not a heck of a lot you can do” about capital gains taxes. But investors can save themselves some aggravation if they examine a fund’s tax potential before investing.

Bregman recommends looking at a fund’s financial statement, where asset details can provide a snapshot of possible shareholder tax costs. For example, a fund with net assets of $109 billion reports that $56 billion of that comes from shareholder purchases and $50 billion from the fund’s unrealized appreciation.

“That tells you right there that almost half the net asset value is appreciated gain,” he explains. “It doesn’t necessarily mean you’ll get hit with a tax distribution, but you could.”

Taxes now help reduce taxes later
Bregman concedes that most investors, however, aren’t likely to go to this trouble. And in the greater investing scheme of things, maybe they really shouldn’t worry about the taxes.

“If you talk to a financial planner,” says Bregman, “he’ll ask ‘What’s the big deal?’ All the distribution does is increase your cost basis.”

Why does that matter? Because even the IRS won’t make you pay taxes on the same investment twice.

The taxes you pay on capital gains distributions throughout your ownership of a fund can be used to increase the fund’s cost basis — the initial cost of an investment plus costs incurred while you own it. You use the basis when you sell your total holdings to figure what portion of the sale is taxable.

For example, if you bought 1,000 shares of Stock XYZ in 2000 for $10 each, your basis is $10,000. If you sold those shares today at $15 each, then your taxable gain would be $5,000 — the $15,000 sale price minus $10,000 basis. You would owe $750 in long-term capital gain tax ($5,000 x 15 percent).

But if you received capital gains distributions, you paid tax for the year you got them. These taxed gains are added to your basis. In this case, you start with your original $10,000 in shares, then add $1,000 in distributions you got in 2000 and another $2,000 paid in 2001. If you now sell all your Stock XYZ for $15,000 you subtract $13,000 — the original cost plus distributions. That gives you a taxable gain of $2,000 instead of $5,000 and you only owe a $300 long-term capital gains tax bill.

Attitude, not portfolio, adjustments
If all this math is making your head spin, the easiest tax advice may be to adjust your mindset rather than your investment strategy.

“What do you expect?” asks attorney and financial adviser Arthur Tarlow with Meyer, Suozzi, English & Klein in Mineola, N.Y. “Do you want to pay no taxes?”

That attitude is unrealistic, says Tarlow, and ultimately counter-productive to securing a good nest egg. If you’re making good investment decisions, your portfolio is earning money and capital gains taxes — particularly long-term ones — are evidence of your financial security.

“I dream of the day when I pay a million dollar capital gains tax,” Tarlow says with a chuckle.