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PREPARATION
Manage Mutual Fund Basis to Minimize Taxes

Good recordkeeping always pays off at tax time. That's especially the case for retirees who have taxable accounts invested in mutual funds.

Most investors automatically reinvest the dividends and capital gains paid by their funds. Each reinvestment, which includes a number of shares and partial shares, has a specific tax basis. The basis is what you paid for the shares. When you sell, the difference between your basis and the sales price is your gain or loss.

And there's the rub: Each batch of shares you buy through automatic reinvesting of dividends and gains has a different basis. If you want to minimize taxes, you need to know the basis of each lot you purchased.

Four ways to calculate basis

You can track the basis of each batch of shares -- usually referred to as a tax lot -- using paper and pencil or with a software program such as Intuit's Quicken or Microsoft Money. Here's a quick rundown of the four IRS-approved methods for calculating mutual fund basis.

First-in/first-out method. With the first-in/first-out (FIFO) method, the shares you sell are the first shares you purchased. If you've owned a fund for years, FIFO will usually result in the biggest tax.

Average-cost method. With this method, you derive your basis from the average cost of your shares. There are two ways to average: single- and double-category. With the first, you simply add up your total cash investments in the fund, including reinvested capital gains and dividends, and divide the total by the number of shares you own. (Double-category averaging involves dividing shares according to how long you have owned them, but this method is usually not worth the effort.) In most cases, an average basis will likely be higher than the FIFO basis, and thus your tax bill will be lower.

Specific identification. This method usually gives you the smallest tax bill. In order to use it, you must direct the fund to sell specific shares (tax lots) that you bought. The basis of each lot determines the tax.

Using the three methods, this is how you might fare. Let's assume that over the past ten years you've been buying shares of Fidelity Magellan by investing $10,000 every December. This year you redeemed 100 shares at $96 a share on April 30, for a total of $9,600. You owe tax on the difference between your basis and the sales price.

With FIFO, your first shares cost $63 each, and your taxable gain is $3,300. You owe a capital-gains tax of $660 (20% of $3,300).

Under the single-category average-cost method, your basis is $91. That's better, but it still generates a taxable gain of $500, and you owe $100 in capital-gains tax (20% of $500).

Using the specific-share identification method, you select a lot you bought in December 1999 with a cost basis of $137 per share. Because you sold at $96 a share, you now have a capital loss of $4,100. If you have capital gains to report, you can offset the loss against the gain.

If you don't have gains this year, you can offset $3,000 of the loss against ordinary income and carry over the remaining $1,100 loss to next year.

You can switch between the FIFO and specific- identification methods of calculating basis, but once you use the average-cost method for fund shares, you must stick with it for as long as you own that fund. For details on basis, see IRS Publication 550, Investment Income and Expenses (800-829-3676).

Better basis tracking is coming

Most fund statements show an average-cost-basis amount, but improvements are coming. Currently, firms such as Vanguard, T. Rowe Price and Charles Schwab don't track specific shares but will sell the lots you identify.

Fidelity has a specific-share tracking system, which allows you to follow up to 150 tax lots per fund dating back to 1987. (Customers who have kept records on prices prior to 1987 can incorporate that information.) Account owners can access their accounts online and determine which tax lots have the highest basis. A Fidelity service rep can also do it for you.