Mutual funds allow you to invest in a managed pool of assets and spread your risk over many different individual investments. The fund will pay you regular dividends from the income it earns from its stocks and bonds. You'll have a choice to take the dividends in cash or reinvest them in more shares of the fund. Either way, they're taxed; if you reinvest them, the dividends will affect your cost basis when you finally sell the shares.
When you sell shares of stock or any other capital asset, you must calculate the cost basis of your investment. This is the price you paid, plus any transaction costs such as broker fees. For a mutual fund, the cost basis is the total price of the shares, plus any sales commission charged by the fund. If you have accumulated shares over a long period, you may have reinvested dividends as well, and this will affect your tax calculation when you sell the shares.
Reinvestment and Cost Basis
Most funds pay out dividends once a year in December. That's taxable income in the year you received the payment, whether you reinvest the dividends or just receive a check. The Internal Revenue Service taxes you either way, but it also considers the reinvested dividends to be part of your cost basis for shares you hold. When you sell, you declare this adjusted cost basis on Form 8949. If you neglect to make this adjustment, you're actually paying income tax twice on the same money -- once when the dividend is paid, then again when you sell the shares.
Capital Gains and Losses
Because you're using the dividends to buy new shares, you increase your cost basis by the amount of dividends you received. The IRS allows you to adjust the basis for reinvested dividends whether or not you take a profit or a loss on the shares. If you do lose money on the transaction, a higher adjusted basis will increase your capital loss, which is deductible up to an annual limit of $3,000. If you reach that limit, you can carry the loss forward to the next tax year.
Basis and Average Methods
If you buy shares of the fund at different times -- and many people do -- the IRS allows several different methods of identifying which shares you're selling. With the average basis method, you add up all the money you paid for all your shares and the dividends you reinvested, and you divide that by the number of shares you hold. Or you can identify specifically which shares you're selling by using the date you bought them or use the "first-in, first-out" method, selling your oldest shares first. You can't use the last two methods if you've already used the average basis. You may have long-term and short-term capital gains to declare, if you've bought shares over a period that's longer than a year.
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