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General rules for determining the amount and type of gain or loss to report when you sell mutual fund shares.
When you withdraw money from a mutual fund account, you're actually selling shares of stock in the mutual fund. As a general rule, that sale results in capital gain or loss. The tax law provides special rules for determining how much gain or loss you have, and in what categories, when you sell mutual fund shares.
Money market funds. There's an exception to the general rule. Most money market funds are set up so that you have no gain or loss when you sell shares to make a withdrawal. These mutual funds constantly adjust the number of shares so that each share has a basis, and a value, equal to $1.00.
It's not terribly difficult to figure the amount and category of your gain or loss if you buy all your shares on the same date at the same price, then sell them all at once on some later date at the same price. But things get more difficult when you buy shares on different dates at different prices, and later sell only some of the shares you own. Which shares did you sell? And what is the basis (cost) of the shares you sold? The rules described on this page are designed to answer these questions.
Finding the correct answer can be difficult for regular stocks, but it's likely to be much more difficult if you invest in mutual funds. The reason is that mutual fund investors tend to accumulate savings over a period of time and often choose to reinvest dividends. This means they have many purchases of shares, often including fractional shares, on many different dates, and all at different prices.
To make things easier for mutual fund investors, the tax law provides averaging rules. You can't use these rules for sales of regular stocks; they're only for mutual funds. You lose some flexibility when you use these rules – but you gain some convenience. It's up to you whether to use these rules. You should elect to use them if the added convenience is more important to you than the loss of flexibility.
Before we turn to the special rules for mutual funds, we should have in mind the rules that apply to other stocks. These rules apply to mutual funds, too. You only use the special averaging rules if you elect to use them, and you shouldn't do that unless you feel that they give you a better result than the regular rules.
Most investors nowadays don't take possession of stock certificates representing their shares. Instead, they leave the shares with the broker, mutual fund company or other entity. But it's still possible for investors to hold certificates. If you do, none of the rules described below (including the averaging rules) apply. Those rules are only for shares that are held in an account. In general, if you sell shares by transferring one or more certificates in your possession, you determine which shares you sold by determining which certificates you transferred.
Example: You bought 100 shares of XYZ at $22, receiving certificate number 11497. Later, you bought another 100 shares at $28, receiving certificate 17866. If you sell 100 shares, the amount of gain or loss you report will depend on which certificate you deliver.
If you sell shares that are held in a brokerage account and don't take action to specify which shares you are selling, the tax law treats you as if you sold the first shares you acquired. This rule is sometimes called the first-in, first-out rule, or the FIFO rule.
Example: You bought 100 shares of XYZ in January, another 100 in March and another 100 in April. In May you sold 150 shares without specifying which shares you were selling. You are treated as if you sold all of the shares you bought in January and 50 of the shares you bought in March.
It doesn't matter if the broker actually transferred some other certificates. The tax law says you automatically sold the first shares you acquired.
The tax law also lets you identify the shares you are selling, so you can choose to sell shares other than the first ones you bought. You might choose to do this, for example, if the newer shares had a higher cost basis, so you would report a smaller gain when you sold these shares. If you properly identify the shares you are selling, then the FIFO rule described above doesn't apply.
Example: Same as the preceding example, but when you sold the shares in May you specified to the broker that you were selling the most recent shares you bought, and the broker provided written confirmation of this instruction. You are treated as if you sold the shares you specified in the instruction.
Specific identification of shares provides you with the greatest possible flexibility in planning the tax consequences when you sell stock — including stock of mutual funds. Relatively few people take advantage of this flexibility, though. If you aren't the type for this kind of detailed tax planning, you may not be giving up much when you elect to use one of the averaging methods described below.
We come at last to the averaging rules. These rules apply only to mutual fund shares. You can't use them for regular stocks. There are two different rules, and you get to choose which one you use.
You'll see that these methods involve some learning, and some calculations. At first it may seem to be more trouble than it's worth. And if it truly is, you don't have to use these methods: they're purely elective. But many people find that after they get "over the hump" of learning about these methods, they make it much easier to calculate gain or loss on sale of mutual fund shares.
When you use the single-category method, you add up the basis of all the shares you hold in a particular mutual fund. Then you divide by the number of shares to determine the basis per share. Any sales are considered to come from the oldest shares first for purposes of determining whether you have long-term or short-term gain or loss.
The double-category method is a little more complicated. You add up the basis of all the shares you have held for a year or less (short-term shares) and find the average basis of those shares. You also find the average basis of the long-term shares. When you use this method, you're allowed to identify whether you are selling short-term shares or long-term shares. Then you determine your gain or loss based on the average basis for that type of share.
The description of the averaging methods above is just enough to give you the general idea. Details concerning the use of these methods appear in the following pages.
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