When you invest in a mutual fund outside of a retirement plan or other tax-deferred account, your investment eventually will be subject to taxes on any gains. There are rules for determining when to pay those taxes and how much you will owe.

Calculating Cost Basis
Short-Term vs. Long-Term Capital Gains


Calculating Cost Basis
When you sell mutual fund shares from a taxable account or exchange them for another fund, you may have a capital gain or loss. To determine the gain or loss, you first need to know how much you paid for the shares, which is your cost basis. Your cost basis includes:

• Your initial purchase
• Additional shares you bought over time
• Any reinvested dividends and capital gains

The IRS allows you to choose among four methods of determining cost basis:

• Average Cost - Single Category: This may be the simplest method. Divide the total cost of your investment by the total number of shares you own to determine the average cost of each share.
• Average Cost - Double Category: This is similar to the previous method, except you calculate two average costs - one for long-term shares owned for more than 12 months and another for short-term shares owned for 12 months or less.
• Specific Share Identification: This method allows you to choose which shares to sell, as long as you identify the shares when you sell them.
• First In, First Out (FIFO): This method assumes that the first shares you bought are the first ones you sold. If you don't specify another method, the IRS will assume that you have used FIFO.

There are advantages and disadvantages to using each method, depending on your tax situation. Your tax advisor can help you decide which method best suits your needs.

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Short-Term vs. Long-Term Capital Gains
Capital gains from shares owned for 12 months or less are short term. Short-term capital gains are taxed at ordinary income tax rates, which can be as high as 35%.

Capital gains from shares owned for more than 12 months are long term. Long-term capital gain tax rates were reduced by the 2003 Tax Act.

If you're in the 15% tax bracket:

• For sales and exchanges through Dec. 31, 2007, your long-term capital gain tax rate is 5%.
• For sales and exchanges in 2008, your long-term capital gain tax rate is 0%.
• Beginning in 2009, your long-term capital gain tax rate will be 10% for shares that you owned for more than 12 months but for five years or less, and 8% for shares that you owned for more than five years.

If you're in a higher tax bracket:

• For sales and exchanges through Dec. 31, 2008, your long-term capital gain tax rate is 15%.
• Beginning in 2009, your long-term capital gain tax rate will be 20% for shares that you owned for more than 12 months but for five years or less, and 18% for shares that you owned for more than five years.

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Information about cost basis and capital gain tax rates can help you analyze your current investments and evaluate your long-term holdings. Talk with your tax advisor regarding your specific investments and tax situation.

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

This article is from the Financial FYI® series produced by the Education and Guidance department of American Century Investments. "Financial FYI" is a registered mark of American Century Services Corporation.


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