My Money Hurts

August 1, 2007 9:37 PM

Financial Newbiefilter: Should I sell this mutual fund I bought when I didn't know what I was doing?

I've recently gotten my finances into a semblance of order. The one festering boil left on my finances is a managed mutual fund I bought five years ago (as of May) when I had a certificate of deposit come due and got strong-armed by a fund salesman masquerading as a financial planner at my banks.

I'd like to get the money out of this dog of a fund and into an index fund of some kind, but the tax implications are making my head hurt.

I've had the fund for five years. In that case a sale would be taxed as a long-term capital gain, correct? Is there any way to further reduce my tax liability if I'm immediately reinvesting the proceeds from the sale in a different fund?

If it matters, I have maxed out my 401(k) and a Roth IRA.

Another complication is that I may be buying a house in a year or so. If I plan to use this money as part of a down payment, am I better off sitting on it than putting it into another fund which I might have to pay short-term capital gains on when I sell?

My brain hurts. Please halp, hivemind.

posted by murphy slaw to work & money (8 comments total)

Yes, you would pay long-term capital gains tax on whatever your gains were. For tax purposes, it doesn't matter what you do with the money afterwards; there isn't much you can do to reduce your taxes on it.

(Make sure you correctly account for any fees you paid, though; they may reduce your cost basis.)

If you plan on using the money within a year or so, I wouldn't suggest putting it back into the stock market*; not only would you be taxed at capital-gains rates on any gains, there's significant risk of losing value. Go for a money market account or high-interest savings account, which should protect your capital and (hopefully) keep up with inflation.

* I'm assuming you were in a stock fund before, but there isn't enough information in your question to tell. Most mutual funds invest in stocks, but there are plenty that do bonds and REITs and other investments too. Saying "putting it into another fund" doesn't mean much; it's the underlying investments that are the interesting part.
posted by xil at 9:48 PM on August 1, 2007

xil: The current fund is mostly in stocks, with a minority in bonds. By "putting it in another fund", I'm talking about stock fund, probably one of the Vanguard index funds.

All your points are well taken. I have a high-interest money market account (where the rest of my down payment is sitting at the moment) where I could stash the money from the sale.

What do I need to do to ensure that I'm properly accounting for fees?
posted by murphy slaw at 10:31 PM on August 1, 2007

There aren't any real fees you can deduct, but you most certainly should increase your cost basis by the amount of the distributions you collected each year if you reinvested them in the fund. Distributions are dividends and capital gains paid by the fund, usually quarterly or at the end of the year. You already paid taxes on those distributions so if you automatically reinvested the distributions, that increases the amount you spent on your investment by exactly the amount reinvested. You would have to look back at your records for the last five years and total them up, unless you mutual fund does the cost accounting for you. If you just took the distributions and spent them, then you can't use them to increase your cost basis.

Keep in mind that you only pay the 15% tax on the amount of the gain, not the amount of the total sale. The gain is the sale price minus the original cost and also minus reinvested distributions.

If you have made a decision to sell, now is as good a time as any. However I would be wary of immediately investing in a new stock fund, even an index fund, if you think you will need the cash in the next year or so.
posted by JackFlash at 11:36 PM on August 1, 2007

In that case a sale would be taxed as a long-term capital gain, correct?

No, not always correct. It depends on the cost basis you have in the fund.

When you buy a single stock and sell it later, figuring the cost basis is easy: it's what you paid initially. You may have to do some simple arithmetic if you reinvested dividends or if the stock split. The amount of capital gains is the sell price minus the cost basis.

When you buy shares of a mutual fund, the calculation is the same. But figuring the cost basis is anything but trivial. The stocks held in the fund accrued dividends; the bonds held in the fund paid interest; and the fund itself may have distributed some of its capital gains or dividends to you as taxable distributions. All these events impact your cost basis. Additionally, the fund may have had some tax-loss-carry-forward, from previously incurred losses, when you bought shares of it; or it may have incurred losses and so sheltered some of its gains; if so, your tax burden would be reduced.

Your accountant and your fund company should be able to help you sort this out. Again, it's not always a trivial exercise; you certainly won't be able to do it without help from the fund company.
posted by ikkyu2 at 12:04 AM on August 2, 2007

Here's a decent link on calculating the cost basis of a mutual fund held over some years.

As far as your second question, about what to do with this money: short-term capital gains (less than 1 year) are treated as ordinary income. If your marginal tax rate on ordinary income (i.e., the amount of tax you'd pay on an additional dollar of income) is less than 15%, you do well to take a short-term capital gain; but if, like the rest of us, your marginal income tax rate is greater than 15%, you do badly to take a short-term capital gain.

Consider further that a lot of mutual funds, including most index funds, create a taxable distribution in December; some also create one in April. If you have held the fund for less than a year these distributions are short-term gains. If, then, you invest just before either of these distributions, some of your money will be promptly returned to you with an immediate income tax bite taken out of it from Uncle Sam - definitely not the wisest use of your investment dollar.
posted by ikkyu2 at 12:12 AM on August 2, 2007

Doc, I think you are making this unnecessarily complicated. Your cost basis in a mutual fund depends only on the amount you invested in the fund, either at the beginning or by reinvesting dividends. That's it. Whether the fund itself accrued capital gains or dividends or whether the fund has a tax-loss carry is irrelevant to computing your gain. Those events are simply passed through transparently to you via the distributions. Once you have paid taxes on the distributions it is irrelevant what triggered them when computing your cost basis and capital gain. It's simply how much did you make minus how much did you invest. You do have to consider if some of your reinvested distributions occurred within the last year. That small portion of your investment would be considered short-term rather than long term, but your 1099 from the fund will calculate that out for you.
posted by JackFlash at 10:25 AM on August 2, 2007

What JackFlash said.

murphy slaw- with the usual disclaimers about me not being an accountant or financial advisor....

You can figure this out using your old statements if you have them. The fund company will not be interested in helping you out. If you have a broker on the account (and I assume the high-pressure sales guy is still listed) he should be able to give you your Long and Short Term Unrealized Gains. If not that, he can at least give you your cost basis.

Long term investment will be your original purchase plus anything that reinvested more than a year ago.

Short term will be anything that reinvested since then.

It MAY make it slight easier that mutual funds are allowed to use an Average buy price. This means you can add up all the money in and divide it by the number of shares you own. You can't do this with any other investment that I'm aware of, but because mutual funds so often reinvest, the IRS has allowed it.

If you've maxed out your 401k & ROTH you probably aren't in the 15% tax bracket, but if you are, your long-term capital gains rate could be as low as 5%. This means that long-term gains are still better than short term ones.

As I've mentioned in other posts, I don't believe in letting taxes be the primary motivator in investment decisions. However, if you think you'll get a big tax hit you might try selling half in 2007 & half in 2008, or some similar strategy.

If you are going to need the money in 3 years you should put it in a CD or savings account or something else that's basically cash. The rule of the universe is that your assets will suddenly lose value just when you need them, and won't recover until it's too late to be useful.

If you get stuck and stressed about the capital gains, email me.
posted by small_ruminant at 11:49 AM on August 2, 2007

Thanks, everybody. All the answers have been helpful.

My plan is to sell it, put it in my money market account (or possibly a 6 or 12 month CD) and work out the taxes with the help of an accountant.
posted by murphy slaw at 9:59 AM on August 3, 2007