How do you calculate the cost basis for a mutual fund over an extended time period?

A:

Investors must pay taxes on any investment

gains they realize. Subsequently, any capital gain realized by an investor over the course of a year must be identified when they file their income taxes. For this reason, being able to accurately calculate the cost basis of an investment, particularly one in a mutual fund, becomes extremely important.

The cost basis represents the original value of an asset that has been adjusted for stock splits, dividends and capital distributions. It is important for tax purposes because the value of the cost basis will determine the size of the capital gain that is taxed. The calculation of cost basis becomes confusing when dealing with mutual funds because they often pay dividends and capital gains distributions usually are reinvested in the fund.

For example, assume that you currently own 120 units of a fund, purchased in the past at a price of $8 per share, for a total cost of $960. The fund pays a dividend of $0.40 per share, so you are due to receive $48, but you have already decided to reinvest the dividends in the fund. The current price of the fund is $12, so you are able to purchase four more units with the dividends. Your cost basis now becomes $8.1290 ($1008/124 shares owned).

When shares of a fund are sold, the investor has a few different options as to which cost basis to use to calculate the capital gain or loss on the sale. The first in, first out method (FIFO) simply states that the first shares purchased are also the ones to be sold first. Subsequently, each investment in the fund has its own cost basis. The average cost single category method calculates the cost basis by taking the total investments made, including dividends and capital gains, and dividing the total by the number of shares held. This single cost basis then is used whenever shares are sold. The average cost double category basis requires the separation of the total pool of investments into two classifications: short term and long term. The average cost is then calculated for each specific time grouping. When the shares are sold, the investor can decide which category to use. Each method will generate different capital gains values used to calculate the tax liability. Subsequently, investors should choose the method that provides them with the best tax benefit.

To learn more, see Selling Losing Securities For A Tax Advantage, Using Tax Lots: A Way To Minimize Taxes and Mutual Fund Basics Tutorial.

RELATED FAQS

  1. What is the minimum amount of money that I can invest in a mutual fund?

    Learn about investing in mutual funds even with a smaller initial investment; there are many funds available to investors ...
  2. What does a mutual fund's beta coefficient measure?

    Evaluate the risk associated with a particular mutual fund by determining its beta coefficient, which illustrates the fund's ...
  3. How can I get a mutual fund prospectus?

    Read and understand the prospectus before investing in a mutual fund. You can obtain a copy from the fund company, your financial ...
  4. Can I purchase mutual funds for my IRA?

    Learn how to invest your IRA assets in mutual funds. Discover a few of the different types of mutual funds available for ...
RELATED TERMS
  1. Historic Pricing

    A method for calculating the value of an asset using the last ...
  2. Multibank Holding Company

    A company that owns or controls two or more banks. Mutlibank ...
  3. Bear Fund

    A mutual fund designed to provide higher returns when the market ...
  4. Short Put

    A type of strategy regarding a put option, which is a contract ...
  5. Ulcer Index - UI

    An indicator developed by Peter G. Martin and Byron B. McCann ...
  6. Wingspread

    To maximize potential returns for certain levels of risk (while ...
Related Articles
  1. Stock Safety: Top 3 Ways to Limit Your ...
    Options & Futures

    Stock Safety: Top 3 Ways to Limit Your ...

  2. Applying Binary Options To Equity Markets
    Options & Futures

    Applying Binary Options To Equity Markets

  3. Can You Buy Stock Insurace? 3 Strategies ...
    Options & Futures

    Can You Buy Stock Insurace? 3 Strategies ...

  4. ETF Options Hedge Risk of ETF Trades
    Mutual Funds & ETFs

    ETF Options Hedge Risk of ETF Trades

  5. How Does Janus's Fund Lineup Look Now?
    Investing Basics

    How Does Janus's Fund Lineup Look Now?

Trading Center