Calculating mutual fund cost basis

[9/24/07] Changes to the law back in 2003 made an already great strategy—holding investments for the long term—a better deal than ever. To recap, realized gains on stocks, bonds and mutual funds held over one year are taxed at the long-term capital gains rate of 15%.1 Short-term gains (on investments held one year or less) are still subject to ordinary income tax, which ranges up to 35%.

Whether short-term or long-term, the gain on your investment is the sale price minus your cost basis, or what you paid. It sounds simple, but calculating your cost basis can be more complex than you might think—and if you calculate it incorrectly, you may overstate your gain and pay more tax than necessary. The accounting method you use to report your cost basis can have a big impact on your tax bill, as well.


[8/18/07] The IRS allows you to use one of four methods when calculating your mutual fund's basis. You'll need to think about this decision before you actually sell anything. Your choice will affect how you treat sales in the future.

• Average cost (single category): Most people (and brokerages) use this method. You add up all of your purchases of the security, including reinvested dividends and capital gains, and divide by the total number of shares you own. To determine whether your gains/losses are short-term or long-term, you assume the oldest shares are sold first. Once you use this method to calculate the cost basis of shares you've sold, you must continue to use this method for the rest of the shares you sell in the future.
  
• Average cost (double category): This is similar to the above method, but first you sort your shares into two categories: those in which your gains and losses are short-term and those in which you have a long-term gain or loss. Then you add up the purchases in each category and divide by the number of shares in each category.
  
• Specific-share identification: This method is a little trickier, but it can also save you money. You specifically tell the brokerage which shares you want to sell and use the cost basis of those specific shares. For example, you may have bought shares of XYZ company five years ago when prices were higher--let's say $15 per share. Then later you bought more shares when the price was lower--say $5 per share. If you specifically tell your brokerage firm to sell the shares that you purchased at $15 and you sell them at $16, you only have to pay tax on the $1 per share of capital gain. If you specified the shares with a $5 cost basis, you'd owe tax on $11 per share.
  
• FIFO (first-in, first-out): If you don't specify a method for calculating your basis, the IRS will assume you're using FIFO. This method assumes that when you sell some of your shares, they are the first shares you bought. If those shares have a lower cost basis, you'll end up owing more in capital gains tax (and vice versa).

When calculating cost basis on stocks, the average cost basis may not be used.