When you sell mutual fund shares, try to use the “specific identification” method. To use this method, you must have a record of which shares you bought when, at what price. At the time of sale, specify to your broker or to the fund company (in writing) which shares you wish to sell. Insist upon a written confirmation, for your records.
When you specify shares to sell, you can select any shares you bought at a price higher than the selling price, for a loss. Among the shares you bought at a lower price you can specify the most expensive shares, for the smallest gains. However, if some of your low-gain shares are short-term (held one year or less), you might want to specify long-term shares instead, to get the lower rate on long-term capital gains.
You’re better off reporting a $200 long-term gain, for example, to be taxed at 20 percent, than a $150 short-term gain, if you’re in a 35 percent tax bracket. By crunching the numbers you can determine the best approach, if you’re willing and able to specify shares when you sell them.
Another tax-saving approach when you sell some of your shares in one mutual fund, is the “double-category” method. Here, you divide all of your shares of a particular fund into two categories, short- and long-term. Purchases and reinvestments within the past 12 months will be your short-term shares and the others will be long-term.
Then you divide each group of shares by the total cost of those shares, to get your average cost for each category. When you sell, you may elect to treat the disposition as coming first from either category. If the short-term shares are the high-cost shares you can treat them as being sold first, effectively selling the shares you bought most recently. This may result in a relatively low tax bill, or even a tax loss.
Suppose you invested and reinvested $2,000 in ABC Fund within the previous 12 months. Those shares are now worth $1,800. If you use the double-category method and sell $4,000 worth of shares, you can elect to have the short-term shares sold first. Thus, $1,800 worth of shares will come from the short-term (high-cost) category, reducing your tax bill, and $2,200 from the long-term (low-cost) category. The average cost for each category will determine your taxable gain or loss.