Tax Planning for Mutual Funds

If you have ever had to go back and find mutual fund records from several years in the past, you know how painful that process can be. You may have been forced to endure searching through several years of mutual fund and broker’s statements or confirmations looking for mutual fund transaction information to have your tax return prepared. If you do manage to find those old statements, you may then be faced with computing the actual cost basis of your mutual funds after allowing for the reinvested fund distributions received each year, additional purchases, and partial sales. However, with an improved record-keeping system and some careful planning, you can avoid the headaches associated with locating investment information, ease the cost basis computation burden, and increase the after-tax rate of return on your mutual funds.

If you elect to reinvest your periodic mutual fund distributions (as many investors do), those distributions generally increase your cost basis for determining taxable gain or loss. Even when your mutual fund distributions are reinvested, you pay taxes on them in the year received [current taxation is not applicable to tax-deferred retirement accounts, such as a 401(k), IRA, etc.], and each reinvestment is like making a new purchase with its own cost basis and holding period. Therefore, when you sell or redeem your mutual fund shares, it’s critical you include that additional cost basis when computing your gain or loss. If you don’t, you may pay double the tax since you were already taxed in the year the distribution was received. Keeping track of that additional cost basis can be complicated, but it's necessary, as keeping accurate records could result in lower taxes.

When you sell or redeem mutual fund shares without liquidating your entire investment position in the fund, you have choices for determining how much cost basis is assigned to the shares sold. If you have purchased shares on different dates and at different prices, the method used can significantly affect the amount of taxable gain or loss and the holding period, which in turn determines whether you qualify for the preferential long-term capital gain tax rates.

Another planning issue relates to choosing mutual funds in which to invest. Although you cannot control the fund’s timing of internal investment sales (and their capital gain recognition and distribution), you can choose a fund that is managed with a level of tax efficiency that fits your particular situation.