Calculating Taxes on Mutual Fund Transactions

Here are some facts and sample calculations for determining capital gains or losses on mutual fund transactions.

The IRS allows three methods for determining the cost basis—First In, First Out (FIFO), Average Cost, and Specific Identification. The Average Cost (or "Average Basis") method, which is the most commonly used, requires you to determine the average cost per share—total dollars invested divided by the total number of shares held. (The other methods are discussed later.) You will need to keep copies of your year-end statements or confirmations to accurately calculate your cost basis.

The Average Cost approach has two variations: double-category and single-category. With the former method, you divide your shares into two groups: those held longer than one year (long-term shares) and those held one year or less (short-term shares). Then, figure the average cost per share for each group. With the single-category method, you figure the average cost per share for all shares held in the account, and any shares that are sold are considered to be those held longest in the account.

T. Rowe Price uses the Average Cost, single-category method of calculating your cost basis. We include this information, if available, on Form 1099-B (mailed in January) for your convenience. You are not required to use it, and we do not report it to the IRS.

• Determining Tax Due—Stock Funds
• Determining Tax Due—Bond Funds
• Using the Specific Identification Method and Other Information

The Average Cost, single-category approach is detailed in the accompanying table. Table I assumes an initial investment of $10,000 made at the end of 2008, two additional investments of $1,000, and all dividends and capital gains reinvested. Such reinvestments are included in your cost basis.

On June 2, 2009, the investor redeemed $2,500 (125.6 shares). The tax cost and capital gain or loss on this transaction are figured in the following steps:

1. Divide the cumulative tax cost (the sum of all investments made prior to the sale) by the total shares in the account to determine the average cost per share:
   $11,723.06 cumulative tax cost ÷ 627.7 shares = $18.68 average cost per share
2. Multiply the number of shares redeemed by the average cost to determine the tax cost of the shares sold:
   $18.68 average cost x 125.6 shares = $2,346.21 tax cost on shares sold
3. Subtract the tax cost from the sale proceeds to determine the capital gain or loss on the shares sold:
   $2,500.00 sale proceeds – $2,346.21 tax cost = $153.79 capital gain

Since the shares sold with the Average Cost method are considered to be those acquired first, and all the shares in this example were acquired within a one-year period, the $153.79 would be a short-term capital gain under current rules. The investor’s new cumulative tax cost after the sale is $9,376.85 ($11,723.06 - $2,346.21); the average cost per share remains $18.68.

On November 20, 2010, the investor exchanged $2,000 (103.5 shares). Exchanges from one fund to another are treated the same as any purchase or sale for tax purposes. The cumulative tax cost prior to this second transaction is $12,105.27. Dividing this by the 642.8 share balance produces an average cost per share of $18.83.

Multiplying $18.83 by the 103.5 shares exchanged produces a tax cost of $1,948.91. Since these shares were held more than one year, the $51.09 capital gain ($2,000 – $1,948.91) would be long term.

The procedure for calculating your tax basis is no different for a fixed income, non-money market fund. (Money market funds are managed to maintain a constant share price, so transactions generate neither gains nor losses.)

Table II presents a hypothetical series of transactions to illustrate the process.

An initial $5,000 was invested at the end of 2009, plus another $1,000 six months later. All monthly dividends were reinvested, further increasing the total cost basis. On December 11, 2010, the investor redeemed (sold) $1,500, perhaps by writing a check against the fund account.

To find out whether the redemption resulted in a capital gain or loss, the investor takes the following steps:

1. Divide the total number of shares in the account on December 11, 2010, into the cumulative cost of those shares to find their average cost per share:
   $6,421.09 cumulative tax cost ÷ 712.1 shares = $9.02 average cost per share
2. Multiply the number of shares redeemed by the average cost to find their tax cost:
   $9.02 average cost per share x 177.9 shares sold = $1,604.66 tax cost
3. Compare the tax cost with the sale proceeds:
   $1,604.66 tax cost – $1,500.00 sale proceeds = $104.66 capital loss

Since the tax cost exceeds the sale proceeds by $104.66, the investor would report a capital loss. And since these shares were owned less than one year, this would be a short-term loss under current IRS rules. In addition, the wash sale rule would apply because the redemption on December 11 occurred within 30 days of the reinvested dividend for November. This would limit the portion of the capital loss that could be recognized.

"Wash sale" rules apply to mutual funds. If you sell shares at a loss, you can’t claim the loss if you purchased other shares in the same fund within 30 days before or after the sale.

Under the Specific Identification method—which the IRS also refers to as "Cost Basis"—you may specify which shares have been sold, identifying them by the trade date on the confirmation statement. The tax cost is the specific cost of those particular shares. You should give the fund written instructions at the time of sale. If you fail to provide written instructions and do not elect the Average Cost method, the shares sold are always the ones held longest—the First In, First Out (FIFO) approach. In any event, you will need to keep a record of all your past purchases so you can accurately identify the cost basis.

If you have never sold shares of a particular investment, you may choose any method—FIFO, Average Cost, or Specific Identification—for determining your capital gain or loss when a sale occurs. The selection of Average Cost must be indicated on your tax return, and, once selected, you cannot switch to a different method for that fund without IRS consent.

Information on determining the cost basis of mutual fund shares is available here and in IRS Publication 564.

For further information on tax matters, you may wish to call the Internal Revenue Service at 1-800-TAX-1040. To receive federal tax forms, call 1-800-TAX-FORM (829-3676) or visit the IRS Web site. Information on mutual fund tax matters is available in IRS Publication No. 564, and information on individual retirement accounts can be found in IRS Publication No. 590.