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Mutual Fund Cost Basis

Calculating the cost basis of a mutual fund is somehow complicated. This article aims to explain what exactly a mutual fund cost basis is and how you can manage it.

Cost basis have tax implications. Therefore you will have to make the appropriate estimations when you have decided to sell the fund. IRAs and 401 (k) plans are not subject to taxes, so the need of calculating the cost basis is eliminated.

Cost Basis Definition

The initial purchase price of a share is what is meant under the tax term cost basis (also known as "basis"). When taxation time comes, the cost basis is used to estimate the capital gains or losses by referring to the Schedule D of IRS form 1040.

Calculating the cost basis of a mutual fund may seem simple but only until you add dividends to the picture. Furthermore, the continued purchase of the same fund represents another factor that complicates the calculations. What further complicates the cost basis calculation is the requirement that every mutual fund have to pay distributions to its shareholders.

Let's do the full calculations in the following example. Imagine that you initially own $10,000 of a fund, which was bought for $10 per share. Therefore, you own 1000 shares. Following this example, your cost basis will amount to $10 per share or $10,000.

Now let's exemplify the complication of the calculations of the mutual fund cost basis and add distributions. We assume that the fund pays distributions amounting to $0.25 per share. You have decided to automatically reinvest these dividends, resulting in $250 reinvestment. Meanwhile, the price of your mutual fund has increased by $5 (the new price is $15). Therefore you can purchase 16 additional shares with the dividends. As a result you now hold 1016 shares. Thus:

Cost basis = the initial $10,000 + the reinvested $250 = $10,250

Weighted average cost = $10,250 / 1016 = $10.089 per share

It is evident from this example that the estimations are not very complicated. However, over the years you purchase more shares and additional distributions are made, which leads to more complicated calculations. If you think that you will not be able to rightly calculate the cost basis, ask your broker or fund company to do it for you. Moreover, this entire administrative nightmare can be alleviated by special software that your broker or mutual fund company own. Nevertheless, do not rely completely on their services and keep the purchase information and yearly statements as long as needed, since they thoroughly report the transactions and prices that have occurred during the year.

Broker or Mutual Fund Company Assistance

Whenever you have any doubts concerning the initial cost of your mutual fund investment, do not hesitate to contact your broker or fund company. They both can provide you with financial records and old account statements, since they keep exhaustive databases with information from previous years. Additionally, when you have decided to sell the fund, you can use their services to make the appropriate calculations of the basis.

Internal Revenue Service (IRS) Assistance

IRS allows investors to select the shares you have sold. In the case of purchasing one and the same mutual fund several times or you have simply reinvested your dividends, the IRS provides the opportunity to select the fund you have bought. In this way you are given the freedom to select the basis you want to apply. You have several options:

  1. FIFO (first-in-first-out) - the purchase that was first made, is the one that is first sold.
  2. LIFO (last-in-first-out) - the transaction that was most recently made is the one that is first sold.
  3. Average cost

These are some of the most important basics about mutual fund cost basis. Even though cost basis calculation appears easy on the surface, don't forget the many factors we have mentioned that complicate the estimation.

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