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Last-Minute Tax Primer for Mutual Fund Investors

Rachel Koning Beals

Many investors look to mutual funds for their convenience. After all, a manager is doing the heavy lifting of picking stocks and navigating the whims of financial markets.

But are mutual funds convenient at tax time?

For the most part, yes. There are, however, a few important considerations to keep in mind. Investors must ask themselves: Do I want some control over taxable gains and losses in order to minimize my tax bill?

[See Avoid These 10 Common Tax Mistakes.]

For starters, there is some basic tax reporting required of investors for the shares of a mutual fund sold during the year. The taxable gain or loss when you sell a fund is the difference between the amount you receive from the sale and the "cost basis" of the shares you sold. See the IRS page on Capital Gains and Losses for more in-depth information.

What's cost basis? Cost basis is the original value of an asset (usually the purchase price), adjusted for stock splits, dividends, and return of capital distributions. Your capital gain (or loss) is then equal to the difference between the asset's cost basis and the sales price. If you got the shares as part of a dividend reinvestment plan, the cost basis is their price at the time of purchase.

The onus has long been on taxpayers to track and report their cost basis to the IRS. Financial firms supplied a 1099-B, sure, but it was up to the filer to get the information to Uncle Sam. The look of that form is changing, as is the responsibility that comes with it. Increasingly, financial firms are now responsible for cost-basis tracking and reporting to the IRS.

Compliance has gone into effect on a staggered basis. Starting with the 2011 tax year, brokerage firms must begin tracking cost basis for stocks. Beginning with the 2012 tax year, mutual fund firms are required to track the cost basis of funds and report to the IRS, as well as continue their reporting to shareholders for filing purposes.

But many fund firms are stepping up ahead of the deadline, said Jeff Latzer, senior analyst for mutual funds at financial services consultancy Corporate Insight.

Companies offer a variety of methods for tracking gains and losses. One way is with "average cost," in which the cost basis is determined by the average price of all shares within a certain lot. This is the simplest method, and requires the least amount of record-keeping. Many fund companies calculate clients' cost basis using this method. But it can limit investors' tax-planning capability.

[See Take Advantage of These Tax Breaks.]

Investors willing to do a bit more work can opt for the "specific identification" method. For it, investors pick and choose the lot of shares to sell. For example, you might opt to sell your oldest shares first (often called First In, First Out, or FIFO). You could opt to sell the most expensive shares. A tax advisor can provide more help on the pros and cons of each method.

Fund firms are increasing the resources available to investors. Fidelity, for one, has expanded its online service offerings to include specific share identification trading and cost-basis information tracking for mutual funds. The firm's recordkeeping and trading capability track detailed historical information such as buy and sell activity, current tax lot information, and positions for Fidelity and non-Fidelity funds.

As you plan, consider taxes, too. Some of the tax-time legwork can take place well in advance of filing season--at the time you make investing decisions. Some mutual funds are "tax-managed," meaning the investment manager strategically decides which stocks to buy and which to hold based on capital gains and capital losses. It's a tough balance. Tax considerations are obviously not their primary goal. Mutual fund managers need to prove fund returns and would likely sell winning stocks to do so. Greater distributions means potentially higher taxes.

Timing your investment is important. Buying late in the year is usually not advisable. That's because, in most cases, mutual fund distributions are issued at the end of the year and you'll pay taxes on those distributions--a year's worth of distributions, in fact, on a fund you've owned for only a few months or less.

[See The Tax-Efficient Frontier.]

Bottom line: There's more to fund-picking than just investment and management style. The approach to taxes and the convenience and support of fund firms at tax time should also inform mutual fund investor decision-making. Be sure to check the prospectus.

Corporate Insight reviewed the scheduling and depth of tax information that 17 major mutual fund firms sent to their customers during tax season. The firm's key findings include:

-- 29 percent of fund companies offer a tax summary online. Fidelity's is the most in-depth.

-- Surprising to the researchers, only one firm it tracked, T. Rowe Price, allowed customers to direct deposit a tax refund back into a mutual fund. Several firms offer this feature, however. The Hartford, for example, allows investors to direct deposit a refund in a mutual fund account.

-- Slightly less than half (41 percent) of the fund firms offered clients the ability to receive email notification of tax-form availability online.

-- The average tax document archive length is five years, the longest being from Oppenheimer (12 years), followed by Fidelity and T. Rowe Price (seven years).

-- American Century and American Funds used banner and image announcements, respectively, to alert clients to tax-form availability. T. Rowe Price was the only firm to employ interstitial messaging.

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