Will you be taxed on your entire $400 gain? No. The total cost of the shares (for capital gains purposes) is the initial $800 paid plus the $100 reinvested distribution on which tax has already been paid, making a total cost of $900. Thus, the taxable capital gain from the $1,200 proceeds received the following year is only $300 rather than $400.

When you dollar-cost-average. If you add to your fund holdings through frequent new purchases, you should be especially careful to keep records of the dates, amounts invested, and number of shares purchased. That's because you will later need this detailed information in order to compute any capital gains when your shares are eventually sold. This is all the more true if you later sell part (rather than all) of your shares.

Unless you say otherwise, the IRS assumes that you sell your shares in the same order as you bought them. This is known as FIFO accounting (First-In, First-Out). If your early purchases were at higher levels, this method will give you tax losses; if your early purchases were at lower levels, this method will create taxable gains. You have other options:

• Calculate the average price paid for all the shares sold. Divide the total dollars invested (including any distributions reinvested) by the number of shares you owned. This could either raise or lower your taxes depending on how the other alternatives work out.

• Send the fund written instructions saying you are selling the specific shares bought on such-and-such a day at such-and-such a price. This gives you the most flexibility for managing your tax liability.

A more complicated variation of the averaging method allows you to separate your shares into two groups based on whether they've been held shorter or longer than one year. You then specifically designate which group you are selling from when each sale is made. Most investors won't want to bother with the hassle of this "Average Cost, Double Category" method, but in some cases the extra effort may pay off in reduced capital gains taxes.

While you can switch back and forth between the default (FIFO) method and specifically identifying shares to sell, if at any point you choose to use an average price method, you must continue to use that averaging method for all future sales of that same fund.

As you can see, dealing with mutual fund distributions in a taxable account can get fairly involved, particularly when you have distributions reinvested automatically. Because of this, we typically advise readers with taxable accounts to not reinvest their fund distributions. While this does require the owner to occasionally reinvest any cash received from distributions, it can greatly simplify tax reporting when a fund is sold.  

December 15, 2010

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