Q.: I have a mutual fund I have been funding with $100 every month for the last 20 years.
The fund has been doing very well. If I sell some, do I need to pay tax or can I just cash out the principal amount? If not, is there a way to save on taxes?
If the fund is owned inside a tax-favored account like an IRA or retirement account, the sale will not generate a taxable gain. Neither gains nor losses in such accounts are reported. Contributions into and distributions out of an IRA or retirement account are reported to the IRS and affect your taxes.
For holdings in a taxable account, you cannot just take the principal amount. If you sell any portion of a holding, the gain or loss will need to be accounted for on Schedule D of your tax return. The gain or loss is determined by comparing the proceeds from a sale to the “cost-basis” of the shares sold. If proceeds are more than basis, a gain is realized. If less, then a loss occurs.
The tax cost depends on your tax bracket and whether the gain is long or short term. The rate for long term gains is always less than short term gains because short term gains are taxed as ordinary income, up to 37% on a federal level. Long term gains are taxed at up to 23.8% but for taxpayers in the lowest brackets, long term gains can be tax free.
In its most basic form, cost basis is what you paid for shares of a holding whether by a direct buy or through reinvested dividends. For instance, $100/month for 20 years is $24,000. Your basis will be $24,000 plus any amounts of dividends that were reinvested in the fund and trading costs.
Using the “average cost” method of accounting, the tax-free portion of a sale mirrors the proportion of the basis to the total value. So, if the entire fund is worth $100,000 and your basis is $24,000, 24% of a sale would be basis and not taxable. 76% of the proceeds is a realized gain. The average cost method is only allowed to be used for mutual funds and most fund firms use average cost as the default accounting method.
In the past, tracking cost basis was the responsibility of the taxpayer. The Emergency Economic Stabilization Act of 2008 included new tax reporting requirements that phased in over the next few years. The law mandating that certain firms report to the IRS the adjusted cost basis of sold securities and whether the gain or loss is short or long-term.
The legislation requires these custodians to use a default cost basis method for calculating gains and losses unless a client or adviser acting on behalf of the client chooses another method for the default or at the time of sale. Once the trade settles, you cannot alter the accounting method used for that transaction.
Most brokerage firms use the First In, First Out (FIFO) as the default method on securities. This is important because each $100 purchase bought a specific number of shares. The FIFO method means that the gain is calculated based on the cost basis of the shares bought first which are usually among the lower cost shares. The result is the reported gain will likely be larger than what would be reported using another method.
Normally once one uses average cost, they are stuck with that method for the life of that fund. The legislation allows clients to move out of average cost to another method but only for shares purchased after the change and only if they subsequently do not use average cost for these newly purchased shares. Since you started accumulating shares 20 years ago, you may have lots of choices about accounting for your sale.
Other allowable accounting methods include Last In, First Out (LIFO), highest cost, lowest cost, and specific shares. The differences can be significant. Back in 2011, we wrote about the legislation and we included an example of how the choice of accounting method can impact the tax bill. It would be worth discussing with your advisers which calculation method would help you before you sell.
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Dan Moisand is a financial planner at Moisand Fitzgerald Tamayo in Orlando, Melbourne, and Tampa Florida. His comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some questions are edited for brevity.