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Chuck Jaffe Archives | Email alerts
April 8, 2012, 12:00 p.m. EDT
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By Chuck Jaffe, MarketWatch
BOSTON (MarketWatch) "” Between finishing your tax return for 2011 and forgetting about taxes until the paperwork arrives for 2012, mutual-fund investors have one more tax chore to do.
WSJ's David Reilly assesses J.P. Morgan Chase's stock buyback plan. Photo: Getty Images.
New tax rules that started last year but which really hit fund investors starting in 2012 mean that investors should be thinking about tax issues now, so that they don't face consequences later that come from doing nothing.
Here's the situation: The Internal Revenue Service rolled out new rules regarding cost basis "” what you paid for your shares "” that began kicking in last year and that go into full effect in 2013.
Under the new system, brokerage firms and mutual-fund companies must track and report shareholders' cost basis directly to the IRS; in the past, investors provided that information on something of an honor system (which is why the government changed the rules).
Brokerage firms began tracking cost basis for stocks in 2011; mutual funds are on board this year; and rules for tracking costs for bonds, options, and other securities go into effect in 2013.
The rules apply only to securities purchased after the effective date for the rules, although some firms started cost-basis accounting shortly after the rules were announced; as a result, if you sold fund shares last year "” depending on the fund's sponsor "” you may have received a tax statement showing your cost basis. (Some firms maintain two separate averages, one for shares purchased under the new rules and another for purchases made before the new rules; you must maintain records for those purchases made before the rules went into effect or work with the firm to ensure that it has an accurate record of costs from before the rules took effect.)
Last fall, fund companies started sending out cost-basis election forms. Most people ignored them.
That's a mistake, if only because it leaves you at the whim of the firm's "default method" for calculating costs. Fund companies favor average cost-per-share as the default choice, while brokerages are more likely to use "first in/first out" (FIFO) for customers who don't specify an accounting method. (Some brokerage firms use averaging for funds and FIFO for stocks.)
None of this matters if your only savings is in tax-advantaged accounts, or if your idea of a sale is "dump everything." If you need to make a partial withdrawal, however, cost-basis matters.
For shares purchased before the new rules went into effect, you can either use average-cost, FIFO or "specific lot identification," where you sell shares from specific purchases. For shares covered by the new rules "” so that brokerage/fund-sponsor accounting is required "” you can also go with "last-in/first out" (LIFO), high-cost (most expensive shares are sold first), low-cost (cheapest are sold first) or "loss/gain utilization," which effectively sells shares with the smallest tax consequences first.
As confusing as that sounds, the temptation is to default to average cost basis. There are consequences.
Say, for example, you bought 100 shares of a fund at $10 apiece, 125 more at $8 each, and 80 more at $12.50. You've invested $3,000 and your average cost per share is $9.83.
Now you need to remove $1,500, and the fund is trading at $12 per share. That means you are selling 125 shares.
Based on average cost, your gain is $2.17. If, instead, you sold the 80 shares purchased at $12.50 and 45 of the shares bought at $10, your average cost per share is $11.60, reducing your taxable gain to just 40 cents per share.
By comparison, under FIFO you'd be selling the $10 and $8 shares; your gains would be even greater.
The circumstances in each situation are unique, depending on prices and timing. One method might work best in one case and be worst in the next.
That said, most tax preparers say that specific selection offers the best chance for minimizing taxes, even if it takes the most work on your part to make the numbers work.
Alas, specific selection is not the default method for anybody.
The good news is that the rules give you options and flexibility, to a point. For example, you can select different cost-basis methods for different accounts, and you can change your cost-basis election at any time before you redeem shares.
What you can't do is change your choice after you make a trade. If you didn't override the default cost-basis method before selling, the default is the method you're stuck with, even if it's more costly from a tax standpoint.
To be safe "” even if you don't expect a sale any time soon "” set up a cost-basis election that works in your favor now, rather than relying on the default. If you can't find the forms sent to you, call the firm or go to its website. The process takes a few minutes; while it might make you grumble about the time wasted, that's better than complaining later about the money you lost because you didn't get this done before making a sale.
Chuck Jaffe is a senior MarketWatch columnist. His work appears in many U.S. newspapers.
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Chuck Jaffe is a senior columnist for MarketWatch. Through syndication in newspapers, his "Your Funds" column is the most widely read feature on mutual fund... Expand
Chuck Jaffe is a senior columnist for MarketWatch. Through syndication in newspapers, his "Your Funds" column is the most widely read feature on mutual fund investing in America. He also writes a general-interest personal finance column and the Stupid Investment of the Week column. Chuck does two weekly podcasts for MarketWatch, and frequently makes guest appearances on television, and on radio shows across the country. He is the author of three personal-finance books. His latest, "Getting Started in Hiring Financial Advisors," was published in the spring of 2010 by John Wiley & Sons. Collapse
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