Good mutual fund records will keep you and the IRS happy
Putting check marks in little boxes can be the beginning of some unpleasant surprises. Investors who are new to mutual funds find this out when they check a box on an application instructing the fund to reinvest all dividends and capital gains. It seems simple and neat: The fund makes some money and it automatically buys more shares. Not only are your old shares growing, you have new shares that can grow, too.
The surprise comes at income tax time. As one reader wrote us recently, ``I have to look forward to paying taxes on money that I cannot see and do not really `have' in the sense of money ready and available for spending. Naturally, this comes as a real jolt.''
The fact is, unless an investor is in a tax-free fund, all earnings from that fund, whether reinvested or taken in cash, are taxable, and the Internal Revenue Service expects the taxes to be paid either at the end of the year or quarterly. If the fund is used for an individual retirement account (IRA), however, you won't have to pay taxes every year, but you'll still need good records for the reckoning when withdrawals begin at retirement.
While the funds can provide information to help avoid some of the shocks, most of the responsibility lies with the investor, who must keep accurate records and maybe do some fancy arithmetic to find out how much tax he owes on which mutual fund shares.
``The IRS doesn't care if you reinvest the dividends or take them in cash,'' says Mary Bolles, director of shareholder relations at Keystone Massachusetts Distributors Inc. in Boston.
Recently, Ms. Bolles notes, telephone service representatives at many mutual funds have had to remind customers of another ``taxable event.'' As the stock market has shown signs of wavering after a five-year upward run, many fund shareholders have moved all or part of their money from equity, or stock funds, to money market funds. That phone call or letter results in a sale of stock, which, if the fund shares have gone up in value, means a capital gain. And this means taxes.
The same thing happens if you exchange shares in one equity fund for shares in another equity fund, Bolles adds. ``And it doesn't matter if you're in a family of funds,'' she says. ``You're moving from one independent fund to another,'' even though it's the same company. ``To the IRS, it's still a `lick and a buy''' - a liquidation and a purchase.
Having to pay taxes on reinvested dividends and capital gains isn't all bad news, however. It can save an even bigger bite when you pull out of the fund. Let's say you invested $10,000 in Fred's Famous Fund in 1982. This year, you've decided that the stock market is out of gas, and since Fred doesn't do very well in down markets, you want out. Now your shares are worth $32,525, a gain of $22,525.
Over each of the past five years, however, you've already paid taxes on $1,850 in dividends and $9,230 in capital gains. That leaves $11,445 additional taxable income this year, not $22,525.
Figuring out exactly how much tax you owe, however, depends on which method you use to determine the ``cost basis,'' or purchase price for tax purposes, of the shares you sold. You can use the specific identification method or the average cost method. Whichever you select, you have to stick with it, although you can apply to the IRS for written permission to change later on.
With specific cost, you have to keep very accurate records of the shares added to your account at any time, their prices, and the quantity and price of any full or fractional shares sold to make a withdrawal.
With the simpler average-cost method, you add up all the money you put in over the years, plus reinvested dividends, to arrive at a total cost. Then divide this figure by the number of shares in your account to come up with a total cost per share. Once you have the cost, you can subtract it from your overall total to get the capital gain. Because recordkeeping is less complicated with this method, it is the one most fund investors use.
Still, all mutual fund shareholders have to keep accurate records, including copies of all statements the fund sends out.
``You have to keep track of your statements and add up your dividends and interest each year,'' says Barbara Levin, spokeswoman for the Investment Company Institute, the mutual fund trade group. ``If you plan ahead of time, you won't have surprises.''
Many mutual funds send out monthly or quarterly statements of all activity in their customers' accounts, as well as the IRS Form 1099-DIV at the end of the year. This form lists the dividend income, net capital gains, and distributions from the fund that represent a return of capital. Some funds, however, don't send any reports during the year, just the 1099-DIV. Another form, the 1099-B, is also sent at tax time and is a record of sales or exchanges of fund shares.
Even if your fund doesn't send reports during the year, you should be able to call and get an up-to-date statement.
A recent letter from the IRS to a congressman opened up another area fund shareholders should watch. Funds will now add certain advisory fees and management expenses to income, and shareholders will be treated as though they had incurred the costs themselves.
Investors can then include these expenses in miscellaneous itemized deductions. But these are allowed only to the extent they exceed 2 percent of adjusted gross income. So you may be taxed on fund expenses you can't deduct, but if you cross the 2 percent level, you'll need records to prove it.
Records can also help save on taxes if you're selling just a few fund shares. Let's say you make a partial withdrawal from Fred's Fund. If you kept accurate records of the price and date of all share purchases, including reinvested dividends, you will be able to identify the shares with the highest purchase price. Then you can ask Fred's phone representative to sell those shares first, to give you a smaller capital gain.
This is especially important now that 100 percent of capital gains are taxed as ordinary income.
If you have a question that would make a good subject for this column, send it to Moneywise, The Christian Science Monitor, One Norway St., Boston, MA 02115. No personal replies can be given by mail or phone.