PICK AND CHOOSE

Within an individual financial plan, allocating assets to achieve diversification is essential to reduce risk and reach investment goals. Due to their popularity, historically positive returns, and ability to achieve such diversification, mutual funds have become a popular investment vehicle for many. If you have made mutual funds part of your financial plan, you should know something about how they are taxed should you choose to sell.

Most mutual fund investors use either the first-in-first-out (FIFO) or the average basis method when figuring their capital gain upon selling their shares. Yet, another method is available which can be a source of maximum tax savings. It is called the specific identification method and may be used provided you meet Internal Revenue Service requirements. The key is to track the cost basis of your individual shares and determine your gain based upon which shares you decide to sell.

An example will prove how powerful a tax saving tool this can be. Suppose you have been investing regularly in a high-performing stock fund for the past few years and decide you want to redeem some of your shares. If you sell the oldest shares under the FIFO method or adopt the average cost method and the share price has steadily increased, you will recognize a substantial capital gain due to the low basis of these older shares. On the other hand, if you sell some of the most recently acquired shares, you will have a markedly smaller capital gain, and therefore less tax. This is because the newest shares were purchased at a higher net asset value (price) and have a higher cost basis.

Take this method to the logical extreme and a savvy investor who acquired shares at varying prices could pick and choose which shares to sell to realize the minimum capital gains. Of course, the shares left untouched would all have a low basis. Yet, these avoided capital gains have lost some of their sting as they are deferred until sale, and as everyone knows, a tax deferred is a tax saved.

As always, IRS requirements must be followed. Generally, if you can adequately identify your shares sold, you can use the cost basis of those particular shares to figure your gain or loss. "Adequate identification" is satisfied if you specify to your account executive at the time of the sale or transfer which shares are to be sold, e.g. the lot, purchase price and date. You must also receive a confirmation in writing within a reasonable time which must confirm your account executive was instructed to sell the particular shares.

Of course, you should consult with your tax adviser and financial adviser first before adopting this strategy. If you have already been using one method, you may be locked into it for an entire lot. This method also requires keeping good records. However, several mutual fund companies are sending shareholders tax cost statements which list date, price, and other information to facilitate this method of share redemption. If you don't already have good record keeping habits or use specific identification, keep this "tax saving" method in mind for future financial planning strategies.