Understanding Mutual Fund Taxation - Brief Article

USA Today (Society for the Advancement of Education), March, 2001 by Jeff A. Schnepper

I RECENTLY HAD DINNER with Rep. Jim Saxton (R.-N.J.) where the topic of discussion was professions--specifically, who had the oldest? The physician on my right insisted that it was his. Wasn't the removal of a rib from Adam to create Eve a surgical procedure? I countered that, in the beginning, God created order out of chaos. I'm a tax planner, so isn't that my job? Thus, I have the oldest profession. My victory was short-lived. Saxton looked up at us, smiled, and asked, "Who do you think created the chaos?"

When we tall about mutual fund taxation, we're talking about chaos. There's inside gain, outside gain, and enough basis complications and convolutions to confuse a convention of wizards. Let's see if I can clarify some of this confusion.

There are two levels of taxation with respect to mutual funds. The first is the "inside gain"--that earned by the fund itself through the operations of the fund. At the end of January each year, your mutual funds send you Form 1099 showing your portion of their inside gain--their dividends, interest, and short- and long-term gains. You report those gains on your 1040, Schedules B and D, and pay tax at your individual rate.

The amount and timing of these gains is pretty much out of your control. Because mutual funds are pass-through entities, they are not taxed on their gains. Those gains are proportionately passed through to you as an investor in the funds. That is why it's important never to invest in a mutual fund just before the date of record--the day the fund will look at its record of owners and allocate to them all the gains and losses from the year's operations.

When you buy into a mutual fund, you are buying into a portfolio of securities, many of which may have been bought many years ago. If the fund manager has been successful, these securities are pregnant with potential capital gains. If you buy into the fund on Dec. 1 and the date of record is Dec. 15, you are going to be taxed on your share of the fund's full year's gains even though you just held the fund for two weeks. Not only are you going to be taxed on those gains, but when you bought the shares, you actually paid for those gains in the price of the shares you purchased.

An investor may really have a problem here. A successful fund will have securities that have incurred significant appreciation. A fund that bought Microsoft years ago would have shown an incredible past earning record as a result of the company's past appreciation. The very growth that attracted you to the fund in the first place is a hidden tax trap in waiting. When that fund manager decides to sell such "high flyers" the investors in the fund will be hit with an enormous capital gain and a hefty tax bill.

In response to this potential tax terror, many investors have elected to shift their dollars into index funds that invest in an index portfolio, and therefore don't have a lot of turnover. The lower the remover, the less gain is recognized and passed through to you.

Saxton has proposed to attack the issue directly. Because of the unfairness in taxing investors on gains over which they have no control, he has introduced legislation to exempt the first $3,000 in inside gain ($6,000 for a joint return) from tax. The numbers are high enough to insulate the average investor without providing a windfall for the wealthy. It is a bill I strongly support.

The second level of mutual fund taxation is the "outside gain"--the capital gain when you sell the fund shares themselves. It's the difference between what you get on the sale and your "basis" in the shares sold. Here is where people pay more tax than they should. Your mutual fund share basis isn't just your original cost. If you had any inside gain and elected to purchase additional shares in the fund rather than to get cash, that inside gain adds to your basis. Otherwise, when you sell the fund, the new shares would yield you more income, without any basis offset.

Some individuals forget to add their inside gain to their basis to reduce their outside gain. It requires them to keep track of each year's reported inside gains, and people either don't know the rules or lack the appropriate records. You shouldn't fall into that trap. Even if you haven't kept all your records, your mutual fund can supply the data you need. If you don't sell all your position in a fund, you have to determine the basis of the shares you do sell. These rules are complicated, and you have several options:

Specific Share Identification. With this method, you ask your broker to sell specific shares bought on specific dates. The cost of those specific shares becomes your basis. Normally, you want to sell those shares with the highest basis in order to minimize any taxable gain.

First In-First Out. Under this method, you assume the first shares bought are the first shares sold. With a rising market, this yields the highest gain.

Average Basis. Under this method, you take your total cost plus reinvested gains and divide that by the total number of shares held for an average cost per share. Then you multiply the per-share average cost by the number of shares sold. Average basis can be computed using either the single category method (where you don't distinguish between long- and short-term gains) or the double category method (where you do separate them).