Basic mutual fund question

I have never owned mutual fund shares myself, but my DW had a T Rowe Price fund in a taxable account when we got married in 2000. Every year I get a reminder of why I had shunned mutual funds when the capital gains statement arrived. I never sold because I didn’t want an even worse tax problem. It was a minor annoyance for a while but lately the cap gains are becoming a moderate annoyance. I have vowed to drain that account first when I retire.

My question is: how will any withdrawals be allocated to taxable and untaxable amounts. Right now I can see that 56% of the balance is classified as “income” (already taxed) and 44% is “market fluctuations”. Will withdrawals be allocated proportionally? Or can I withdraw all of the “income” first if I choose?

My question is: how will any withdrawals be allocated to taxable and untaxable amounts.

Let’s start with the right terminology. That will help in understanding what has happened and what will happen.

the capital gains statement

What you have is not a capital gains statement. It is a 1099-DIV. It reports the dividends paid to you (or DW) from owning shares of stock in a mutual fund. Mutual funds are slightly funny corporations. If you own shares of stock in something like AT&T, you will get dividends. But before AT&T pays those dividends, they have to pay their income taxes on their earnings. Then they pay some of the remaining earnings out to shareholders as a dividend. Then the shareholders pay taxes on those dividends.

But a mutual fund gets a special tax break. As long as a mutual fund pays out the vast majority of their earnings as dividends, the fund itself (remember, it’s a corporation) doesn’t have to pay income tax on it’s earnings. A second benefit is that the dividends paid to shareholders (that’s you and DW) get to retain their character. So a mutual fund that collects qualified dividends from the companies it invests in gets to pass those qualified dividends to shareholders. Or a mutual fund that collected municipal bond interest gets to pass that non-taxable interest through to its shareholders. And the same thing happens with capital gains. When the mutual fund has a long-term capital gain from selling its investments, those gains get passed through to shareholders. Short term capital gains get a slightly short shrift, as they become non-qualified dividends. Still taxed at the same rate, but loses its nature as a capital gain. That could be important to a shareholder with capital losses - they can’t use the fund’s short term gains against their personal losses in the way they can with the fund’s long-term capital gains.

You’ll note above that I said the mutual fund pays you dividends. And you may be asking where are those dividends. After all, it appears that you never got a check (or a direct deposit, or anything similar). Well, you could have received the money. But it’s likely that DW elected to have those dividends reinvested way back when. So when the fund pays a dividend, they use the dividend to buy more shares of the fund. For tax purposes, this is treated as two separate transactions. First, the fund pays a dividend, which you get taxed on. Then the dividend is used to buy more shares of the fund.

how will any withdrawals

There are no withdrawals from a mutual fund. You own shares of stock. Shares of stock must be sold to convert them into cash. So just like any other stock sale, you calculate your gain or loss on the sale by taking the sale proceeds and subtracting your cost of those shares. The difference is your gain or loss.

But what is the cost (often called basis or cost basis) of the shares? Another excellent question. And one where you may not like the answer. Your cost is determined by each separate purchase, including the purchases from reinvesting dividends. Since it appears that the fund was first purchased sometime before the year 2000, you will have a data gathering exercise on your hands. Assuming some occasional investments and quarterly dividends and 20+ years of ownership, you may have 100 or more separate purchases to deal with. ***(See note)

So you don’t really allocate a “withdrawal” between “income” and “market fluctuations”. Those phrases have no meaning in a tax context. You have to calculate your cost basis of the shares sold and compare that to the sale proceeds to calculate a gain or loss.

That’s all well and good if you sell all of your shares at once. But what if you just sell some of the shares? Are those the shares from the original investment back in the 20th century? Are they from a dividend reinvestment in 2009? Or are they the shares from the most recent dividend? The answer can be “yes”. They could be from any of them. But they don’t have to be.

You have three options to determine which shares you sold. You can sell the shares on a First In, First Out (FIFO) basis. That is, the oldest shares are sold first.

Or you can specifically identify which shares you are selling. So you can sell 10 shares, with 3 of those shares coming from the original purchase way back when, 6 of the shares from the April 2013 dividend, and one more share from the most recent dividend. So you dutifully look up the basis of those specific shares and use that to calculate your gain or loss AND whether that gain or loss is short term or long term. In my slightly wacky example, that 1 share is probably short term, while the others are definitely long term.

This option has a couple of hoops to jump through, mainly identifying the shares before the sale happens and getting your broker or the mutual fund company to acknowledge your identification of the shares you sold. The process for doing this will vary from fund to fund and broker to broker. So you’ll need to find out how it works in your specific situation.

Lastly, you can use an average cost basis. This is only available to mutual funds, not to stock in common companies. So make sure to read carefully when you find things that say you can’t use an average cost. They are almost certainly talking about ordinary companies and not mutual funds. The process for figuring that average cost is pretty straight forward. Take the dollar total of all of your purchases (again, keeping in mind that a dividend reinvestment is just another purchase) and divide by the number of shares owned. That gives you your average cost per share.

–Peter

***(Note) You will likely get some assistance from TRP with this. Since around 2008 - 2010 or so, brokers and mutual funds have been required to keep track of your basis for you. And many did so long before they were required to. So it’s possible, but not a guarantee by any means, that TRP can tell you what your basis is. And it’s possible they could provide you the information on all of your purchases and reinvestments so you can calculate your basis. Either way, you’ll only need to deal with the older information. The basis for the last decade plus a couple of years is already being tracked for you.

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Peter,
Thanks for decoding my language and explaining the basics.

My online access to the account doesn’t have any information going back to 1995 when DW first invested.

EXCEPT, under the performance tab. There, the current balance is broken down as:

EndBalance = BeginningBalance + Additions - Deductions + Income + MarketFluctuation

And there is a Glossary of terms below. I added up the cap gains and dividends from 1099-DIV back to 2000 and that total is very close to their Income number. In other words, I have paid taxes on that amount, right?

Beginning Value – The total dollar value of all accounts included in the analysis for the beginning date chosen.

Additions – Any transactions to move money into your account(s), such as the purchase of new shares or units, exchanges or transfers from any other accounts, and dividends invested in an account from another account. It does not include income or market fluctuation.

Deductions – Any transactions to move money out of your account(s), including redemptions, withdrawals, exchanges or transfers to other accounts, or checkwriting activity. Any applicable redemption fees are also included in the deduction amount. Proceeds from any income that is not reinvested in the same account (cash dividends paid to you and dividends invested into another account) are also reflected as a deduction. Also included is any money out of your account as a result of a fee or commission.

Income – Any proceeds (cash or reinvested dividends, short- and long-term capital gain distributions) earned in your account(s). Income that is not reinvested in the same account (cash dividends paid to you and dividends invested into another account) is reflected as a deduction.

Market Fluctuation – Any increase or decrease in the value of your account(s) over the period selected caused by the changes in the investments’ beginning and ending share or unit prices (net asset values). If all of your holdings are money market funds, there should be no change in value due to market fluctuation, although this is not guaranteed.

Ending Value – The total dollar value of all accounts included in the analysis for the ending date chosen.

Change in Value – The difference between the beginning value and the ending value for the specified time period.

I have just one small correction to Peter’s otherwise excellent explanation, but the correction isn’t relevant to your circumstances.

Lastly, you can use an average cost basis. This is only available to mutual funds, not to stock in common companies.

Average cost basis can be used for common stock in one specific circumstance. If you acquired common stock shares through a dividend reinvestment program after 2011, you can elect to use average cost basis (similar to a mutual fund).

Ira

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And there is a Glossary of terms below.

Yes - all roughly what I would assume.

The point is that these are interesting things to know from an investment perspective, but they are not what you need for tax purposes. And these amounts could - and probably do - apply to a whole portfolio of funds held at T Rowe Price. For tax purposes, you need to look at each individual mutual fund separately, not the whole portfolio.

Then, to get into the weeds, these terms you list aren’t terribly useful for income tax purposes. They don’t help you get to the tax figures you need. Worse, they’re close but have subtle and important differences. For example, the Deductions figure is problematic. That amount includes both sales of shares in a mutual fund PLUS dividends that were not reinvested. Sales of shares would need to be reported on your schedule D. But you can’t use this Deductions amount to determine the sale proceeds, since it also includes Dividends that were paid in cash or invested in some other TRP mutual fund in your portfolio. *** And Additions is not going to be your basis. It includes your investments using outside money, which is part of your basis. But it does not include the reinvested dividends, which are also part of your basis. You can’t add the Income amount to get the reinvested dividends, because it includes ALL of the dividends and capital gain distributions, whether reinvested or not.

In other words, I have paid taxes on that amount, right?

Yes, but irrelevant to determining your gain or loss on the sale of shares of a mutual fund.

Let me toss a question back at you. Do you have more than one mutual fund in this account a T Rowe Price? Or just a single mutual fund?

–Peter

*** I also think their definition isn’t great for investment analysis purposes, either. Why would deductions include dividends invested in a different mutual fund in your portfolio? That amount wasn’t deducted from the portfolio. It’s just a confusing term that combines too many things into one number.

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Let me toss a question back at you. Do you have more than one mutual fund in this account a T Rowe Price? Or just a single mutual fund?

Thanks again. I’m not trying to be obtuse – I’m just suspecting that there will be no good way to reconstruct the basis (not knowing the historical share prices). So I’m seeking an indirect way, based on what I do know.

Fortunately, the answer to your question is that this is the only mutual fund that was ever in this account. And it has had very little activity over the years. Aside from the many re-invested dividends.

There have been no dividends that were not re-invested. There was only one Deduction, back in 2000.

So, doesn’t Market Fluctuation represent the gains that have not been taxed?

I’m just suspecting that there will be no good way to reconstruct the basis (not knowing the historical share prices).

I think the data is available - you may have to dig. I would start with the MF name at the T Rowe Price web site. If you can’t find it there, Morningstar is likely to have it. You don’t have end of year statements from taxes ?

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Thanks again. I’m not trying to be obtuse – I’m just suspecting that there will be no good way to reconstruct the basis (not knowing the historical share prices). So I’m seeking an indirect way, based on what I do know.

I solved this problem two different ways.

The first was that I paid a mutual fund a “research charge” and they recovered the transactions for me. It turns out that the research charge was more than it turns out I made on the damned mutual fund, so if I just used a basis of $0.00, I would have been better off.

The second, I just donated the damned fund to charity. If you can afford to do this, IMAO, this is the easiest way to go. Pick a tax-deductible charity, of course.

Pete, I wish there was a super-rec, because your post is worth 10 of most rec’d posts.
Wendy

If you don’t want to research the cost basis of the reinvested dividends, the easiest way is to use a a basis of zero for anything you can’t document. That’s what the IRS will assume if they question your basis and you can’t adequately document the number you used. You may be spending more time trying to find a work around than it would take to do the research.

It looks like the Average Cost basis is available on the TRP site. Thanks especially to Peter, who told me what to look for.

The current balance is allocated between Cost Basis Amount and Total Unrealized Gain or Loss.

The second, I just donated the damned fund to charity. If you can afford to do this, IMAO, this is the easiest way to go. Pick a tax-deductible charity, of course.

Long term held stock can be donated to DAF (Donor Advised Fund). It is a way to bunch donations into a single year to help exceed the standard deduction then make donations from the fund over time which can be multiple years.

I’m just suspecting that there will be no good way to reconstruct the basis (not knowing the historical share prices).

You don’t actually need to know the share prices. They can help, but they are not necessary. What you need to know is the number of shares. And you need to know dollar amounts.

For average cost, you take the total dollars invested, including dividend reinvestments, then subtract out the cost basis of any shares sold. Divide that sum by the number of shares currently owned.

The cost basis of the old sale can be found on the tax return for that year. Which is likely in the shredder at this point in time. (Unless you are a pack rat like this Peter guy and have your personal tax returns filed away back to the date you were married in 1982. Yes, they’re now scanned and not in paper form.)

Assuming that 2000 tax return is no longer available, you can figure a cost basis that’s probably close to what was used back then. Do the same calc as above, but only include purchases and reinvestments through that old sale date. And you’ll need to know the total number of shares owned just before the sale as well as the number of shares sold. Calc up the average cost of the shares, then use that average to determine the cost for the number of shares sold. Subtract the cost of the shares sold from the total cost, then keep moving forward. Lather, rinse, and repeat for each sale. (Which is only one for you, but there are lurkers out there reading my drivel. It may help them.)

Of course, before you do all of this, I’d get on the phone with TRP and ask the nice customer service people if they can provide the cost basis for “uncovered sales”. That buzzword means sales of shares purchased before financial institutions were required to keep track of basis. Many will routinely provide that information as a supplement to the formal 1099 they issue each year.

If there are any tax pros out there who have seen a T Rowe Price mutual fund sale recently, perhaps you’d be so kind as to comment on the contents of their 1099s. I don’t recall any among my clients in the last couple of years.

–Peter

I’d get on the phone with TRP and ask the nice customer service people if they can provide the cost basis for “uncovered sales”.

I actually found that already. In post 133556 I didn’t elaborate but I now have the cost basis for the covered and uncovered shares.

Funny about saving tax returns though. When I looked for the year 2000 1099 I was shocked that I only had tax returns back to 2001. I have no memory of tossing anything like that. (I could have stopped at “I have no memory”)

But since I have the cost basis for all the shares I think I’m in good shape.

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