By Glen Janken, CFP®, CLU
A client of mine came to me with what seemed a simple problem last year. He had speculated in residential real estate only to find himself upside down in two deals as prices fell. Unlike many others in southern California, he had managed to unload the houses before the market froze up altogether. But each deal had saddled him with losses and debt. Worse, as a retiree living off Social Security, a pension, and dividends from his mutual funds, the losses would not do him much good come tax time.
What to do?
I resisted the temptation to wag my finger and remind him that speculating in real estate had not been part of the financial plan I put together for him some years back — a plan he had followed in disciplined fashion, by and large, until housing prices started going through the roof.
"You've done well with your mutual fund investments," I told him, looking at his five accounts on my computer screen. "In fact, with some of them you've done well enough that we could take some gains to offset your housing losses. Why don't we see which ones will do you the most good? You could use part of the gains to pay down the debt, and if we reposition the rest in funds with good income possibilities, you can pay down the rest of it over time."
My client readily agreed. After all, it was hardly a revolutionary idea; if investors show gains and losses in their investment portfolios, it often makes sense to offset one against the other. Prudent investors follow this strategy with their holdings of individual stocks without blinking an eye. Why not investors in mutual funds?
Beware Painful Tax Consequences
That, however, is more easily said than done. Like most mutual fund investors, my client had not bought all of his shares in the five accounts at the same time and just held onto them. He had begun with an initial cash investment and followed with others, padded with reinvestments of dividends and capital gains. In addition — and again, like most other investors — he had occasionally sold shares in three of his five accounts, in each case using average-cost basis accounting for tax reporting purposes.
I did not recognize it at the time, but that was the fly in the ointment. Why? Because average-cost basis accounting-the default strategy for the mutual fund industry-makes for one-size-fits-all tax consequences when investors sell their mutual fund holdings. The alternative, tax-lot basis accounting, gives investors far more flexibility in tax planning, but the industry makes investors jump through some hoops to take advantage of it.
Under what circumstances can investors use tax-lot basis accounting? What must financial planners do to make the strategy available to their clients?
Mutual funds are the investment vehicle of choice for millions of Americans who have neither the time nor the expertise to manage their own holdings. But when the time comes to sell, most investors their let broker/dealers do the work of calculating their tax basis, too, and this leads many investors to hand over more money than necessary to the government in taxation. In effect, when investors sell mutual fund holdings, broker/dealers, and the clearinghouses through which they effect trading in mutual funds, give the investor little say over which shares go to market for sale. Instead, when a clearinghouse gets an order to sell, say, 100 shares of a mutual fund on behalf of an investor, the clearinghouse typically sells a random lot of 100 shares from among the investor's holdings, no matter how long the investor has held those particular shares, and no matter what price the investor paid for each one.
At the end of the year, for tax purposes, the investor receives from the broker/dealer a statement showing only the gross proceeds of the sale — that is, a statement saying nothing about the investor's cost basis of the shares involved in the transaction. This leaves it up to the investor to do the calculation, and although most broker/dealers give investors access to software that helps do the job, the software usually defaults to average-cost basis accounting for mutual funds.
For the unwary investor, the tax consequences can be painful. This is not to say, of course, that the mutual fund industry goes out of its way to make taxation worse for investors. But the industry giants — for example, T. Rowe Price, Vanguard, and Fidelity, and many of their competitors — opt for average-cost basis accounting as their default method of reporting share sales. Charles Schwab — used by many independent financial planners as a clearinghouse — allows investors to opt for either average-cost or tax-lot basis accounting, depending on their tax planning needs. Meanwhile, Citigroup and most of the big wirehouses give investors an option to use tax-lot basis accounting when selling both stock and mutual fund holdings; indeed, the players in this arena compete for the attention of investors by offering sophisticated strategies to limit the impact of taxation, of which tax-lot basis accounting is one of the simplest.
How Financial Planners Can Help
The good news for financial planners in all of this is that they can help their clients overcome the problem with some simple record-keeping procedures and a few computer keystrokes.
The first step is to inspect the taxable accounts of all existing clients to distinguish between those who have bought and sold shares in a given account from those who have bought and held their shares without selling. Those accounts showing any sales at all should be labeled "ACB" accounts, or average-cost basis accounts. Those showing no sales should be labeled "TL" accounts, or tax-lot basis accounts.
It is important to distinguish ACB from TL accounts because tax law permits tax-lot basis accounting only for investors who have never used average-cost basis accounting for shares sold in a specific mutual fund account in a specific account. Put another way, investors cannot change horses in midstream; once they use average-cost basis accounting, they must continue to use the method for sales in that fund in that account — meaning all shares bought or sold in the past or in the future. They cannot, in other words, amend past years' tax returns to switch from one method to the other. In addition, once investors have sold shares of a particular fund in an account and used average-cost basis accounting to report the gain or loss, they cannot in the future distinguish new purchases in that fund from existing shares and use tax-lot basis accounting for the new and average-cost basis accounting for the old.
These restrictions narrow the options for many investors — possibly even for most, since it is the rare investor who buys shares in a mutual fund only to put the investment aside without selling any part of it. But even for the investor who has bought and sold shares in a given account, not all is doom and gloom, since it is possible to limit the impact of these restrictions. Assume, for example, that an investor owns shares in three Fidelity funds — a stock fund, an international fund, and an index fund. If the investor has sold shares in the stock fund using the average-cost basis method, he or she must stick with that option for that fund, even for shares bought in this fund in the future. If, on the other hand, the investor has never sold shares in the international or the index fund and wants to realize gains here so as to offset losses elsewhere in an investment portfolio, it is permissible to switch to tax-lot basis accounting before selling any shares in these particular funds, even though the investor uses average-cost basis accounting for sales of shares in the third fund.
Some planners suggest it may be possible to convert any investor's holdings to tax-lot basis accounting by selling the entire interest in a given mutual fund and then buying a new interest in the same fund. There has been no court or IRS ruling on such a strategy, but it does not appear to violate the intent of laws governing switching between average-cost basis and tax-lot basis accounting. Under such circumstances, of course, the planner must keep an eye on wash-sale rules whenever a transaction involves losses and, where there are gains or losses, determine whether tax-lot accounting might outweigh the impact of any taxation upon selling shares in the fund.
A Happy Ending — with Some Effort
In short, there is no reason not to use tax-lot basis accounting for clients who have never sold shares in a given mutual fund and, of course, for new clients making new investments. There is also no reason not to switch for existing investors, as long as circumstances permit. And as the accompanying sidebar shows, the record-keeping is relatively simple. It just takes work to get it done, as I learned in pursuing the matter on behalf of my retired client.
I expected no trouble in picking and choosing which shares to sell to offset my client's real estate losses, but just to make sure, I phoned NFS, the clearinghouse that handles mutual fund transactions for my broker/dealer, with a simple question:
"I have a client who wants to sell specific low-basis shares so he can offset losses elsewhere in his investment portfolio. How do we do this?"
The answer seemed equally simple:
"Go to your conversion page in your client's folder and convert from average-cost to tax-lot basis accounting."
"That's it? That's all I have to do?" I asked.
Not quite. When I pulled up the conversion page for each of my client's accounts and checked the box next to each fund to convert it to tax-lot basis accounting, an ominous warning appeared at the bottom of the conversion page, saying in effect that I should check with a tax professional to make sure that tax-lot basis accounting was appropriate for my client.
(The text of the warning read: If the taxpayer sold shares of a position and used the Average Cost/Single Category method to calculate and report cost bases and gain/loss to the IRS, you should not request that we convert the manner in which we track and report cost basis information. Consult a tax advisor or the IRS for more information about changing/converting cost basis information.)
Mystified, I called my contact at NFS again. He seemed mystified, too, and pushed me upstream to an in-house tax specialist.
"The warning notice," I told the specialist, "tells me it might violate tax law if we convert from average-cost to tax-lot basis accounting for my client. Why?"
"Has your client bought and sold shares of any fund in this account in the past?"
"Yes," I said.
"That's the problem. Once you sell shares of a fund in a given account and use average-cost basis accounting to report those sales for tax purposes, you have to continue to use average-cost basis for that fund in that account."
I pressed the issue. What would happen if I checked the tax-lot box and ignored the warning?
"You can do that and your computer records won't scramble, but you may be violating tax law, and we can't take responsibility for the error. That's what the warning message you got really means."
"So the key," I said, "is whether or not my client has sold shares of a fund in a particular account, right? And we can use tax-lot basis accounting for those funds of which he has not sold any shares?"
My tax attorney agreed. As it turned out, my client had bought and sold shares in most of the funds in three of his accounts but not in the other two. Hence we were unable to convert all the funds in those three accounts in which he had sold shares in the past to tax-lot basis accounting, but we converted the funds in the remaining two with just a couple of clicks. Later, when submitting the order to sell, I specified the particular shares that we wanted to send to market and phoned my clearinghouse to make sure we got the results we wanted.
That made for a happy ending. But two aspects of the experience stand out in my mind. The first is that whatever its merits in the eyes of the mutual fund industry, average-cost basis accounting violates a maxim of financial planning-namely that, where possible, the investor ought to minimize taxation. The second is that the mutual fund industry uses average-cost basis accounting as the default strategy despite the fact that tax-lot basis accounting is the obvious option for the investor seeking to offset gains and losses. This makes no sense. Brokerage houses offer tax-lot basis accounting to investors who buy and sell individual stocks as a matter of routine. The mutual fund industry should follow suit.
Clearly, the deck is stacked against the investor who wants to take advantage of the tax benefits inherent in tax-lot basis accounting. But the question is not "When does it make sense to use tax-lot basis accounting?" The question should be "When does it not make sense?" Every investor faces a different tax situation in a given year, but when that situation includes either big gains or big losses, the financial planner should take the lead in keeping proper records of the client's purchases and sales of mutual fund shares so that, come tax time, the client can take full advantage of the method's benefits.
The Devil in the Details: Eight Easy Steps to Good Record-Keeping
Financial planners have a duty to educate their clients on the advantages of tax-lot basis accounting-and to establish record-keeping procedures designed to preserve their clients' ability to use the strategy.
The following procedures assume the financial planner effects mutual fund transactions through National Financial Services LLC. Financial planners linked to other clearinghouses may adapt the procedures to their own needs.
- Examine the taxable accounts of all clients to distinguish those accounts with funds showing sales since inception from those accounts with funds showing no sales.
- Label those accounts showing sales as ACB accounts, for "Average Cost Basis." Note that all accounts in which shares in any fund have been sold belong in this category, even those accounts with funds that have had no sales since inception along with funds in that account that have had some sales since inception.
- Label those accounts showing no sales at all as TL accounts, for "Tax Lot Basis." Note that this category will contain only those accounts in which no sales of any funds have ever taken place.
- For all TL accounts, on the conversion page, check the box to select tax-lot basis accounting for all future sales and purchases in that fund. (See Figure 1.)
- Label all new accounts involving only new investments-as distinct, that is, from accounts brought in by the client from another financial planner or broker/dealer-as TL accounts. For these accounts, on the conversion page, check the box to make the TL method apply to all future purchases in that account.
- Before selling shares in any fund, make sure that the account is properly labeled, whether ACB or TL.
- Before selling shares in any ACB account, check to see whether the fund in question shows prior sales. If not, on the conversion page, check the box to convert this particular fund to TL status before selling the shares. Note that it may take a day or two for NFS to make the back-office change to TL status, and you should wait to sell until this is complete.
- Similarly, before selling shares in any TL fund, make sure that the TL box on the conversion page is checked. In addition, if appropriate, determine which lots of shares purchased at what points in time will yield the tax benefits sought by the client and instruct the clearinghouse to take only those specific shares to market.