No one should pay more income tax than the rules require. But if you don't know all the rules, it's easy to make mistakes that can be costly.

Here are seven tips to help make you a tax-wise mutual fund investor:

1. Choose the most tax-advantaged way to determine the cost of your mutual fund shares. When you sell shares of a mutual fund, you owe tax on your gain. But determining the gain can be tricky, especially if you've invested at various times. The IRS allows you to choose among several methods to determine the cost of your initial investments, which is called your cost basis. The easiest is the Average Cost — Single Category method. This is the sum of the cost of all shares you've purchased divided by the total number of shares you own. The result is your average cost per share. Average Cost — Double Category is similar to the single category method, except you calculate two average costs: one for long-term shares (those held for more than 12 months) and another for short-term shares (those held 12 months or less). Another method — called First In First Out (FIFO) — assumes that the first shares you bought are the first shares you will sell. A fourth method, Specific Share Identification, allows you to identify individual shares you wish to sell. Each method has its own tax implications and you should make your selection only after careful consideration.

2. Keep your records. As a long–term investor‚ you may find yourself selling shares that are five‚ 10‚ 15 or more years old. That’s why it’s important to keep your annual mutual fund statements with your other important papers. These statements include the price of the mutual fund shares you bought through the years.

3. Don't forget reinvested dividends. When you automatically reinvest dividends, you increase the cost of your shares (cost basis) and decrease the taxes owed upon sale. If you forget to include dividends in the cost of your investment‚ you might pay taxes on gains you never realized.

4. Avoid check writing features on mutual funds other than money market funds. If you write a check against a bond fund‚ for example, you have sold bond fund shares and caused a taxable event. Write several of these checks and the recordkeeping can become difficult. Money market funds seek to preserve the value of a share price at $1. When you sell $1 shares that you bought at $1, there is less of a chance that the sale will be a taxable event.

5. Consider the tax implications of exchanging from one fund to another. Even if you're electronically transferring shares of one mutual fund to another mutual fund, you are selling the shares of the first fund and buying shares of the second. The sale of the first fund is a taxable event unless the funds are in a retirement plan or other tax-deferred account.

6. Review your withholding or estimated tax payments if you make a big sale. If you do not have enough tax withheld by the end of the year, you could owe taxes on your gain as well as an IRS penalty. If you're making a sizeable sale, consider talking to your company payroll department about adjusting your withholding to accommodate the taxes you'll owe. Another option is to make an estimated tax payment to cover the additional taxes.

7. Check out year–end distribution dates. This often occurs in December. You may want to delay purchasing shares in a fund until after this date, which is called the ex-dividend date, to avoid taxes on an investment you just made.

Questions & Answers:

Are capital gain distributions on a tax-exempt fund taxable?
Yes. All capital gain distributions are subject to federal income taxes. They may also be subject to state income taxes. Check with your tax advisor for information about your specific situation.

When can I expect to receive an IRS Form 1099-DIV from my fund company?
Most companies send that information to shareholders in January.

This information is for educational purposes only and is not intended as tax advice.

Related Information: Calculate Cost Basis to Determine Capital Gain

This article is from the Financial FYI^® series produced by the Investor Education department of American Century Investments. “Financial FYI” is a registered mark of American Century Proprietary Holdings, Inc.

Learn more about American Century Investments