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. How are blue-chip stocks similar to mutual funds and exchange-traded funds (ETFs)?

    Understand the primary differences between making investments in blue-chip stocks, mutual funds and exchange-traded funds ...
  2. What is the difference between a stop loss order and a limit order?

    Learn how to manage losses and reduce risk in volatile markets while reviewing the differences between stop-loss orders and ...
  3. What are some of the most popular mutual funds for investing in the metals and mining ...

    Explore some of the many mutual fund options available to investors that focus on holdings in the metals and mining sector, ...
  4. What types of items can you buy futures for?

    Learn what items futures may be purchased for, what a futures contract is and discover how the futures markets have greatly ...
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 ...

You May Also Like

Related Articles
  1. Options & Futures

    Give Yourself More Options With Real ...

  2. Options & Futures

    The Future Is Now: All About Futures ...

  3. Options & Futures

    How To Protect A Short Position With ...

  4. Options & Futures

    How To Build Valuation Models Like Black-Scholes ...

  5. Options & Futures

    A Detailed Look Into China's Options ...

Trading Center