Roanoke Times
Copyright (c) 1995, Landmark Communications, Inc.
DATE: MONDAY, March 7, 1994 TAG: 9403040254
SECTION: BUSINESS PAGE: A-8 EDITION: METRO
SOURCE: By MAG POFF STAFF WRITER
DATELINE: LENGTH: Medium
An estimated 25.8 million American families - 27 percent of all households - own shares in mutual funds, according to the Investment Company Institute, the mutual fund industry's trade association.
That means additional tax problems for many people.
The Institute of Certified Financial Planners has provided a primer to help make the task a little easier.
The simplest situation is for those who made no change in their investments. That includes those who owned mutual fund investments during 1993, but did not sell any shares or switch funds within a family of funds.
If you are among that group, you should have received by now a 1099-DIV form from each fund declaring any taxable distributions the fund made during the year, such as dividends and capital gains. You pay taxes only on those distributions.
But if you sold - "redeemed" - shares, or if you exchanged your shares for units of another fund in the same mutual fund family, the task becomes more complicated.
Consider this example:
In 1990, you purchased 100 shares in the Can't Lose Mutual Fund for $1,000. In 1993, you sold all your shares for $2,000.
But the financial planners said you are probably paying too much tax if you pay on the difference between what you originally invested in the fund and what you received by selling them, or $1,000 in this illustration.
That's because during the two years, the planners pointed out, the fund likely declared dividends and capital gains. Presumably, the fund automatically reinvested those distributions for you, which is usually the wise choice.
Also, you may have made additional investments, buying more shares in the fund.
Thus, your basis, or the total of what you invested in the fund, was actually higher than the original $1,000.
If the previously taxed dividends and capital gains, plus your investments, amounted to $500, then your basis is $1,500. You will be taxed on the remaining profit of $500.
If you sell only a portion of your shares, the task becomes yet more complicated.
Let's say that, in addition to your original $1,000 investment, you bought additional shares on two occasions: 50 shares at $20 each and 50 shares at $5 each.
If you ignore any reinvested distributions, you now have a total investment of $2,250.
In late 1993, you sold 100 shares at $15 each or $1,500.
What then is your tax basis?
The institute said that the Internal Revenue Service gives you several options for calculation. Here are three of them:
\ Average cost:
With this method, you determine the average price you paid for all your shares. In this example, that's $2,250 divided by 200 shares, or $11.25 a share.
You multiply this by the number of shares you sold, in this case 100.
The result of $1,125 is your cost basis. You'll be taxed on the difference between the sales price for the 100 shares (or $1,500) and their cost basis (or $1,125). That gives you a profit of $375 that is subject to taxes.
\ First in, first out:
Typically, this method produces the largest gain (or the smallest loss) because over the long run, stock prices generally rise. In this example, the IRS assumes you're selling off the first shares you bought - 100 shares at $10 each for a cost basis of $1,000. You'll be taxed on the difference between $1,500 and $1,000, or on $500.
\ Designated shares:
This method often works out to be the best, because you can keep the basis higher and the gain lower by designating which shares to sell.
By designating the 50 shares bought at $20 each and 50 more shares bought at $10 each, the total basis is $1,500. Thus, there is no tax.
There are two drawbacks to this method, however.
First, you must tell your broker or mutual fund representatives exactly which shares to sell. That means keeping good records and getting all sales instructions and confirmations in writing.
Second, once you use this method - or any of the other methods - you must use it until all shares of that particular fund are sold. Thus, at some point, you will be forced to designate the shares with the lowest cost basis.
Really confused? If you need more detailed information, call the IRS toll-free at (800) TAX FORM and ask for Publication 564.
by CNB