Get Ready for New 2012 Investment Tax Rules

Mutual fund investors may need to choose how to value their shares for 2012 taxable transactions.


The world of mutual funds is getting more complicated. Funds have long been marketed as an easier and more diversified alternative to buying individual stocks, but mutual fund owners may face more complex tax rules for transactions made in 2012. The law triggering these changes was passed way back in 2008 as part of a flurry of economic bailout and stimulus bills.

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Among those 2008 measures was a provision requiring investors to adopt a consistent cost basis for valuing any securities they sold. Further, it required investment brokers to report this cost basis to the IRS on annual 1099-B forms sent to the IRS. The new rule took effect in 2011 for stocks bought and sold this year and will apply to mutual funds bought and sold in 2012.

Generally, stocks bought before the beginning of 2011 and mutual funds bought before the start of 2012 will not be covered by the new reporting rules. But keeping track of these different purchase dates and which securities are covered or not covered can get confusing, especially for investors who make regular changes to their holdings.

People who hold mutual funds in a 401(k) or other tax-deferred accounts need not worry about the new rules so long as any sales of funds are not taxable and all funds remain inside their accounts. And when such investments are liquidated, their cost basis is irrelevant because all the proceeds of such securities sales are normally taxable as ordinary income.

However, for taxable investment accounts, investors will need to make sure their tax returns use the same cost basis for transactions as that indicated on their 1099-Bs. Confused yet? Wait until we tell you about the different choices you can elect for how to determine the cost basis of your shares.

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"It is making us investors stop and think, 'What does this all mean and what should I do about it?'" says Maria Bruno, a Vanguard specialist in investment counseling and research. Prior to this rule, Vanguard provided cost basis details to investors as a courtesy, but it was up to investors to independently report such costs on their tax returns. "Now, what I report on my 1040 [tax return] in terms of cost basis and gains must match what Vanguard is reporting," she explains. The firm is encouraging its clients to make cost basis decisions now, and it has a resource center on the topic.

The cost basis that is commonly used by investors, Bruno says, is simply to tote up the average per-share price of all purchases of the same security. Comparing this price with the sale price of any taxable share sales can yield the amount of any taxable gain. While this choice is an easy "set and forget" option, it often does not qualify for the best tax treatment on securities sales.

To minimize taxes, Bruno explains, it can make sense to sell the cheapest or most expensive shares. If the market value of the security has declined when it is sold, for example, you may wish to use a cost basis that allows you to sell the lowest-cost shares. But if your investments have appreciated, selling your highest-cost shares can minimize your taxes.

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Choosing such a "specific identification" cost basis is permitted under IRS rules, and there are several such approaches that can be used. Perhaps the most common among them is known as "first in, first out," or FIFO. This approach assumes that the first shares of a security you bought are also the first ones to be sold in any transaction.

The new rules are flexible in letting investors change their cost basis. Such changes once had to be made in writing to the IRS, Bruno says, but now can be made to an investor's broker.

Perhaps the biggest change in investor thinking is that the cost basis of a security sale needs to be selected at the time the security is sold rather than the following April when most people file their annual tax returns. "That's different for investors," she says, "because a lot of them didn't think about this until they did their taxes."

Twitter: @PhilMoeller