Lipper Research Senior Analyst Don Cassidy on "Business for Breakfast" 1060 KRCN - Funds and Taxes

A. Yes indeed! And, in fact, funds are one of the few places where you cando little things in 2006 that might affect your net 2005 taxes...

Q. You mean funding your 2005 IRA account by the end of this week?

A. Yes, if you can deduct the contribution, and a SEP if you run your ownbusiness, but there is more.

Q. Little tax tricks?

A. All perfectly legal, and people might want to talk to their tax advisorsfirst...

Q. We're listening...

A. Two things: First, if you sold any fund shares in 2005, be sure you haveyour correct full cost basis so you don't overtax yourself...

Q. Isn't the total amount you originally paid your cost basis?

A. Not if you reinvested any distributions! When you buy more shares withthose distributions, whether they be income or capital gains in nature,don't forget to add the cost of the added fund shares to your originalcost, to get the full cost if you sold out all your shares.

Q. That last point, about "if you sold out all your shares" can be anotherplace for possible problems, right?

A. Exactly. A few years back I saw a good piece of advice from JonathanClements at The Wall Street Journal. He said, to keep things simplest, itis often best to sell a fund out completely if you sell at all. Then youdon't need to keep records of remaining (unsold) share blocks and so on.

Q. But suppose people do sell only part of their shares in a given fund. Dothey have choices on what their cost basis is?

A. Yes, they do. You need to be consistent, but there are three methods ofdetermining cost:

• First In, First Out
• Average Cost
• Specific Lots

Q. Okay, let's go over those briefly.

A. Sure. The first one, namely "first in, first out," means you take thenumber of shares you sold in 2005, go back to all shares you owned, andfind the earliest shares you bought that you did not already sell in 2004or earlier. Those shares have a specific cost, and you would use that asyour block cost per share for your 2005 sale.

Q. Right, and "average cost" sounds fairly easy too.

A. Well, it can be, if you keep good records. You take all the shares youbought and all the dollars you paid (include those reinvested distributionshere!) and compute an average cost per share. Then you use that cost pershare on the number of shares you sold in 2005 to get the cost of what yousold.

Q. And finally, "specific lots"?

A. That is for a stock you bought at various times over the years. You canchoose now, in 2006, which lot(s) to report as what you sold in 2005.

Q. So, if you bought a technology fund in 1999 at a high price and moreshares in 2003 at the lows, you could report the cost of the 1999 sharesand thus show a loss or a smaller profit for tax purposes?

A. Right. But of course you need to keep sharp records showing what youdid, so you don't make the mistake of reporting "selling" that samehigh-cost 1999 block again in future years.

Q. And you said to be consistent?

A. Right, in any given fund, you need to adopt one method and stick withit. The IRS is understandably not happy if you switch methods to keep usingthe best one each year as markets change. So again, you need to keep goodwritten records!

Q. Do these things really make much difference?

A. Definitely. For example--not even using a technology fund--let's look at ahealthcare fund. Suppose you bought it in mid-1999, and it paid bigcap-gains distributions in 1999 and 2000. Each distribution knocks down theNAV per share. And it kept paying smaller distributions each year. Your1999 block of shares and those reinvested in 1999 and 2000 would nowprobably show a loss you might use for tax purposes. Your reinvestmentshares from 2002 and later would probably show gains, since the NAV wouldhave been lower. So, if you decide to use specific lots as your method, youcould have very different results.

Q. In general, how should people decide where to hold their funds?

A. A very interesting point. You are talking not about asset allocation nowbut about asset location.

Q. Right. Some people say, put all your bond funds and real estate fundsinto your IRA or 401(k) accounts...

A. Well, except for any muni bonds, I'd tend to agree...

Q. But what about wanting to shelter capital gains distributions fromcurrent taxes?

A. That's where it gets to be a tough trade-off. It's easy if you have aRoth, since there will be no tax to worry about. But in a tax-deferred IRAor similar account, you will pay tax--but later--at the high regular-incomerate, so putting funds or stocks in there so you don't pay current taxescan backfire, if you tend to hold long term. But if you are young anddeferring for a long time, it might still work out better. If you do a lotof shorter-term trading, yes, sheltering them in the IRA makes sometime-value sense.

Q. Sounds like one of those areas where people need to "consult your ownexperts" though...

A. Definitely!

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Don Cassidy is a Senior Research Analyst at Lipper specializing in fund flows, exchange-traded funds, (ETFs), closed-end funds, equity fund performance, and author of Trading on Volume (McGraw-HIll).