In 2023, 116 million individual U.S. investors owned mutual funds, according to the Investment Company Institute. However, despite their popularity, the tax regulations related to selling mutual fund shares can be complicated.
The Basics
If you sell mutual fund shares that have increased in value and you've owned them for more than a year, the profit you make is called a long-term capital gain. The highest federal tax rate for this type of profit is 20%, and you might also have to pay an extra 3.8% net investment income tax. However, most people will only pay a 15% tax rate, and some might not have to pay any tax at all.
When you sell mutual fund shares, you calculate your gain or loss by comparing the sale amount to what you originally paid for the shares. One tricky part is that some mutual fund transactions are considered sales for tax purposes, even if they don't seem like it. Another challenge is figuring out the original purchase price of the shares you sold, which is known as your basis.
The basis is calculated:
The Shares Basis = Cash Investments + Commissions + Sales Charges Paid
Selling Mutual Funds
If an investor sells all their shares in a mutual fund in a single transaction, figuring out the basis is fairly straightforward.
Mutual Fund Basis = (The Shares Basis + Reinvested Distributions) – Return of Capital Distributions
However, it gets more complicated if you sell only part of your shares and bought those shares at different times for different prices. Here are a few methods you can use to determine the basis:
First-In, First-Out (FIFO): The basis of the earliest acquired shares is used for the shares sold. If the price of the shares has gone up over time, the older shares will likely have a lower basis, which can result in a higher gain.
Specific Identification: You specify which shares to sell at the time of the sale. For example, you might tell the fund to "sell 100 of the 200 shares you purchased on June 1, 2020." To do so, you must get written confirmation of this request from the fund. This method can help you lower your tax bill by selling the shares with the highest basis first.
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. This method averages out the cost of all the shares to determine the basis.
Selling Funds Unknowingly
A sale that happens when an investor sells all their mutual fund shares and receives the money is a clearer process. The same goes for when an investor asks the fund to sell enough shares to get a specific amount of cash.
What’s less obvious is when a sale happens from you exchanging funds within the same fund family. For instance, if you trade shares of an income fund for an equal value of shares in the same company’s growth fund, it counts as a sale of the income fund shares even though no cash is involved.
Another example is writing checks on your mutual fund account. Many mutual funds allow you to write checks against your account balance. Each time you do this, it’s considered a sale of shares from your fund, even if it doesn’t seem like it.
If you encounter any of the situations mentioned above, it is crucial to understand the tax implications before proceeding with the transaction. To ensure you make the best decision, discuss your options with your trusted VAAS Tax Advisor. You can schedule an appointment or send us an email. As always, we are here to assist you and provide advice on the best strategies to achieve the most favorable tax outcome.