Year-End Tax Planning for Mutual Funds

As the end of the year approaches, it’s a good time to review your financial situation and consider strategies for lowering your tax bill. Following are a couple year-end tax planning tips for mutual fund investors.

Harvest gains or losses

One of the most powerful year-end strategies for investors is to “harvest” gains or losses. This means selling investments to generate a gain or loss. For example, if you realized substantial capital gains earlier in the year, you might sell some mutual fund shares or other investments at a loss to soften the tax blow.

Conversely, if you have a net capital loss for the year, up to $3,000 of that loss can be offset against wages or other ordinary income. The remainder is carried forward to future years. To make the most of the loss this year, you might sell appreciated mutual fund shares or other investments and use the loss to wipe out the gain.

You can even buy the investment back immediately if you wish to hold onto it, with your cost basis reset at its current market value. Note, however, that if you sell at a loss, there are different rules that apply with respect to the basis of the shares that you immediately reacquire.

Manage basis in mutual fund shares

If you invest in mutual funds regularly, you’ll likely buy shares at different times for different prices. So, the method you use to account for your cost basis can have a big impact on your gain or loss when you sell shares.

Your taxable gain or loss is equal to the difference between the sale price and your adjusted cost basis: The higher the basis, the lower the gain (or the greater the loss) and the lower the basis, the higher the gain (or the smaller the loss).

For mutual funds, generally there are three methods of accounting for basis:

  1. First-in, first-out (FIFO), which assumes that the first shares purchased are the first shares sold,
  2. Average cost, which assumes that all shares were purchased for their average price, or
  3. Specific identification, which allows you to specify which shares are sold each time you make a sale.

Although the first two methods are simpler to use, specific identification gives you greater control over the tax consequences of mutual fund shares and facilitates tax planning. For example, suppose you own three lots of 1,000 shares of a mutual fund with a current market value of $100 per share, or $100,000. Lot 1 was purchased in 2017 and has a basis of $50,000, Lot 2 was purchased in 2018 and has a basis of $80,000, and Lot 3 was purchased in 2019 and has a basis of $110,000.

If you sell 1,000 shares for $100 and you haven’t selected an accounting method, the fund will likely use FIFO by default. That means it will sell Lot 1, generating the highest possible gain: $50,000. Had you used the specific identification method, you could’ve instructed the fund to sell Lot 3, resulting in a $10,000 loss. Or, perhaps you have a net capital loss of $23,000 this year. In that case, you might sell Lot 2, generating a $20,000 gain to offset the portion of the loss that’s not deductible from ordinary income.

Choose the right method

To avoid tax surprises, it’s critical to understand a mutual fund’s options for calculating basis and to choose a method — usually specific identification — that gives you the most tax-planning flexibility. Keep in mind, however, that some popular online trading platforms make it difficult, or even impossible, to use the specific identification method.

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