How to sell your mutual fund shares

By Dana Dratch • Bankrate.com

Selling shares of a taxable mutual fund account can be as simple or as complicated as you want to make it. But whatever you do, you need to ask some questions upfront and keep records, just in case Uncle Sam comes knocking.

Next, ask your mutual fund representative about the preferred sales methods and what paperwork fund management will provide to help you sell and report it.

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Finally, pick your sales method.

There are three basic ways to sell mutual fund shares, says Keith Lawson, senior counsel for the Investment Company Institute, a Washington, D.C.-based trade association for the mutual fund industry.

Here’s a look at the pros and cons of each:

Average cost basis

This is the simplest way to sell shares and by far the most popular. But once you elect to use average cost basis for a particular fund, you’re locked into using it until all of the account’s shares are gone, says Lawson.

As the name indicates, the price of all shares is averaged, with your profit or loss based on the average amount paid for all your shares.

For example, if you bought 100 shares of a fund 20 years ago for $5 each and bought another 100 shares last year for $15 each, then cost averaging assumes you own 200 shares and paid $10 each.

So what’s the problem with cost averaging? Imagine your $15 shares are holding their own, still worth just $15. If you sell them, cost averaging assumes you’ve turned a tidy, taxable profit of $5 a share. You haven’t.

But many investors accept such inaccuracy in share values for the method’s ease. All you need is your year-end statement with the average cost information and a transaction receipt showing the number of shares you sold at what price, says Lawson.

Specific identification

This is probably the most complicated sales method. You specify which mutual fund shares you want to sell, based on the shares’ age and actual cost. In some cases, it can reduce taxable gain. But you’re likely to face some problems.

First, many funds don’t do it, says Bob FitzSimmons, a Lincoln, Neb. certified financial planner and former national board member of the Financial Planning Association. Recently, he called four of the fund families he deals with and asked about their ability to sell specific shares. He found three large companies couldn’t do it and one smaller one could.

From a practical standpoint, the funds can’t do it, FitzSimmons says. Then the question becomes, if the fund family can’t execute it, can you document it?

And it’s up to the investor to make sure the transaction is properly documented. That means you must be able to prove, should the Internal Revenue Service ask, that before the sale you designated that you were selling specific shares, says Lawson. [And] shortly after the sale, he notes, regulations require a confirmation of such specification.

If you opt for this method, experts advise that you establish a paper trail. You’d better have your instructions to them in writing, says Barry Picker, New York-based CPA and author of Barry Picker’s Guide to Retirement Distribution Planning . Don’t do it over the phone because then you have no evidence.

One of the best things to have available is a contemporaneous letter, says Brian Mattes, principal with The Vanguard Group mutual fund firm. If questioned, he says, you’ll need to demonstrate how you calculated your gains or losses. To do that you need proof of when you acquired the shares and the cost. You also need confirmation of the sale and the price.

For folks who invest a certain amount every month and end up purchasing fractional shares, selling this way can be a nightmare. What could be problematic is that you could be selling against multiple purchase confirmations, says Picker. And that, he says, requires more elaborate instruction.

When it specifically works

Specific share identification can, however, be beneficial for some investors.

Its major tax advantage, Mattes says, is that it gives meticulous investors a measure of control over the taxes.

It also can be a boon to older accounts with shares acquired at many different times, says Mattes. Lawson concurs, noting that specific identification is likely to provide the biggest benefits to people who have accumulated shares in a fund over a long period. The wider the difference between lower and higher-[priced] shares, the more advantage to using specific identification, Lawson says.

And the method is only for those selling some of their shares. If you liquidate 100 percent, it should come out relatively similar to the average cost basis, says Stuart Sorkin, a tax attorney with Frank & Associates, a Bethesda, Md.-based law firm. But if you sell half, there could be a substantial difference.

First in, first out

Otherwise known as FIFO, this is the method the IRS will assume you used, says FitzSimmons. For that reason, it’s also known as the default method.

Here, the government assumes you are selling fund shares in the same order you collected them absent proof of anything else. In a textbook economy, the oldest shares are usually the cheapest, generating the most taxable gains.

FIFO works much the same as specific identification. You need to be able to document when you acquired your first shares and what you paid. Depending on the age of the account, you might have to come up with this paperwork on your own.

But since this is the default method, the tax collector gives you the benefit of the doubt. So you don’t need proof that you elected to sell your oldest shares first, says Lawson, just the purchase records. In fact, if this is your first sale from the account, you don’t even have to choose between employing FIFO or average cost basis until tax time rolls around, he says.

Dana Dratch is a free-lance writer based in Georgia.

— Posted: Dec. 18, 2002