The Tax Consequences of Selling Mutual Funds

Investing in mutual funds is popular, with 116 million individual U.S. investors owning mutual funds in 2023, according to the Investment Company Institute. However, the tax rules surrounding the sale of mutual fund shares can be complex. Here’s a breakdown of what you need to know.

Understanding the Basic Rules

When you sell appreciated mutual fund shares that you’ve owned for more than one year, the resulting profit is a long-term capital gain. The maximum federal income tax rate for this gain is 20%, and you might also owe the 3.8% net investment income tax. However, most taxpayers will pay a 15% tax rate, and some may even qualify for a 0% rate.

The gain or loss from selling mutual fund shares is measured by the difference between the sale proceeds and your basis in the shares. Certain mutual fund transactions, which might not seem like sales, are treated as such for tax purposes. Determining the basis for shares sold can also be challenging.

Recognizing a Sale

A sale is obvious when you redeem all shares in a mutual fund and receive the proceeds. It’s also clear if you direct the fund to redeem a specific number of shares for a dollar payout.

Less obvious are sales that occur when swapping funds within a fund family. For instance, exchanging shares of an income fund for shares of the same company’s growth fund is considered a sale, even though no money changes hands.

Another example is writing checks on your mutual fund account. Each time you write a check on your fund account, you’re effectively selling shares.

Calculating the Basis of Shares

If you sell all your shares in a mutual fund in a single transaction, determining the basis is straightforward. Add the basis of all shares (actual cash investments), including commissions or sales charges. Then, add distributions that were reinvested to acquire additional shares and subtract any distributions that represent a return of capital.

The calculation becomes complex if you sell only part of your interest in the fund and acquired the shares at different times for different prices. Here are methods to identify the shares sold and determine your basis:

1. First-in, First-out (FIFO): The basis of the earliest acquired shares is used for the shares sold. If share prices have been rising, older shares likely have a lower basis, resulting in more gain.
2. Specific Identification: At the time of sale, you specify which shares to sell. For example, “sell 100 of the 200 shares purchased on June 1, 2020.” You must receive written confirmation of your request from the fund. This method can minimize the tax bill by selling shares with the highest basis.
3. Average Basis: The IRS allows you to use the average basis for shares acquired at different times and kept with the fund or a custodian agent.

Conclusion

Mutual fund investing can lead to complex tax situations. If you have questions or need clarification on how these rules apply to your specific circumstances, we can provide the necessary guidance. Contact us for assistance with your mutual fund investments and tax planning.