When share prices of mutual funds started falling in 1994, money poured out for the first time in years. If you're one of those nervous types who liquidated shares to stem losses, another headache is around the corner: income taxes.
What's involved? A blizzard of paperwork and a complex calculation. First, get ready to round up yearend statements for each fund--not just for 1994 but going back to the year you opened the account. If you're missing some, for a nominal fee, you can obtain past statements from your fund in about four to six weeks. Meanwhile, each fund company will send you 1099-Bs, which list 1994 share redemptions, and 1099-DIVs, which list ordinary income, capital gains, and nontaxable dividends.
The 1099-DIVs get listed right on Schedule B of your Form 1040. It's the 1099-Bs that cause stress, because you've got to calculate your "cost basis," or the purchase price, for the shares you redeemed during 1994. With individual stocks and bonds, you can usually pinpoint the shares you bought, whereas most investors are constantly adding new shares to mutual funds--either through dividend reinvestments or periodic contributions. After a while, you could have thousands of shares with hundreds of different purchase prices.
LUMP SUMS. Since it can be difficult to track the actual shares you are selling, the Internal Revenue Service allows you to use a formula. There are four permissible methods. Specific identification, in which you tell the fund which shares you want to sell, often results in the most favorable tax result because you can unload the costliest shares first and hold down gains. But if you didn't write your letter in 1994, prior to your sales, you can't use the method now. First-in, first-out (FIFO), which assumes the first shares purchased were the first ones sold, is the least desirable. That's because the stock market rises over time. So if you're selling your cheapest shares first, you're likely to incur the highest taxes. Remember: If you don't specify a method, the IRS assumes you're using FIFO.
Chances are, you'll be using some form of average cost, where you simply divide the total cost of your shares by the total number of shares purchased. Investors in the 31% tax bracket or higher can make separate calculations for long- and short-term gains, thus benefiting from the 28% capital-gains rate. But most people prefer to simply lump all shares together. The drawback: You're likely to report a profit--and owe tax--even though the market dropped in 1994.
Let's say you bought 100 shares of a mutual fund for $10 per share, or a total of $1,000, on Jan. 1, 1990. On July 1, 1994, you bought 10 more shares for $20 each for a total of $200. On Dec. 1, 1994, you sold 30 shares at $18 per share. The total cost of the shares equals $1,200 divided by the total of 110 shares purchased, for an average cost of $10.90. Your 1099-B shows proceeds of 30 times $18, or $540. Your cost: 30 times $10.90, or $327, leaving a gain of $213.
TIME BANDIT. In real life, of course, it's more complicated. You don't typically invest in nice round lots of 100 shares. Your $1,000 probably buys some fractional number. Compound that with dividend reinvestments and various transactions, and you can see that you're going to be busy.
More large fund companies now provide average cost data on yearend statements. But the funds haven't solved the problem entirely. For one thing, you can only use the cost data if you've been using the same accounting method for previous sales. And shares that were acquired by gift or inheritance are not included in their cost calculations.
Also, data from many funds go back only a few years. "I'm working on a return where the client originally purchased the fund in 1962, and we've got reinvested dividends every year," says James Vonachen, a tax partner with Clifton, Gunderson in Denver. "If he would have kept notes on a yearly basis, it wouldn't be a project. But now we've got 30 years to go through." If your case is anywhere near as complicated, there goes most of your free time for the next few weeks.
Figuring The Cost Of Fund Shares
AVERAGE COST (SINGLE CATEGORY) This method requires you to divide the total price by the total number of shares purchased. If your fund provides this data, that's probably how it's done.
AVERAGE COST (DOUBLE CATEGORY) Separate calculations are made for short- and long-term gains. This method takes more work, but with the long-term capital-gains rate at 28%, it may pay off for investors in the 31% tax bracket or higher.
SPECIFIC IDENTIFICATION You must write to the mutual-fund company and indicate which shares you're selling prior to the sale. Because you can unload the costliest shares first, this method can offer the best tax result. But if you didn't write in 1994, you can't use it this time.
FIRST-IN, FIRST-OUT This assumes the first shares purchased were the first sold. It's likely to provide the highest tax during a rising stock market. But over many years, the tax burden from FIFO and average cost tend to equalize.