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 does the end of the quarter mean for portfolio management?

    Take a deeper look at why the end of a financial quarter, and all of its accompanying reports, is a significant event for ...
  2. What are the most common momentum oscillators used in options trading?

    Read about some of the most common technical momentum oscillators that options traders use, and learn why momentum is a critical ...
  3. How are Bollinger Bands® used in options trading?

    Use Bollinger Bands to identify volatility changes and place options trades at the right time; profit in bull or bear markets ...
  4. What's the safest way to invest in high-yielding dividend stocks?

    Learn about some of the most important safety factors that you need to consider before you invest in high-yielding dividend ...
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. Pimco has stabilized its Total Return fund, but its returns are still shaky and its sales load is still a fat one.
    Professionals

    A Look At Pimco's Total Return Fund ...

  2. 10 equity mutual funds bargains for any investor or financial advisor.
    Professionals

    10 Equity Mutual Fund Bargains

  3. Options & Futures

    Stock Futures vs Stock Options

  4. Africa's economic growth and growing stability has gotten the attention of adventurous investors. What kind of ETF or mutual fund options are available?
    Mutual Funds & ETFs

    Destination Africa: These Funds Offer ...

  5. First time stock investors may ask, is there any way to buy insurance on stocks to prevent losses?
    Options & Futures

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

Trading Center