Full disclosure: What follows is much nitty-gritty about mutual funds and taxes. This may be excuse enough for you to turn the page--if you don't mind paying Uncle Sam more in capital-gains tax than is necessary.
There's good news on this front. Minimizing tax bills has just become much simpler for a big bloc of fund investors. In April, the largest fund firm, Fidelity Investments, introduced Web tools that let fund holders pick which specific shares they want to sell and then go ahead and sell them online. Charles Schwab (SCH) told me it offers this online service only to clients with at least $1 million in assets. Beyond that, none of Fidelity's top rivals have something similar online.
If you're thinking, "So what?," chances are you have never tried to lower your capital-gains tax by using what the Internal Revenue Service calls "specific share identification." (For the deadly details, you can download IRS Publications 550 and 564 at www.irs.gov/forms_pubs/pubs.html or see the Jan. 28 BusinessWeek Investor section.) Selling funds this way is obscure and time-consuming enough that only a minority of investors know of it and even fewer use it. A good broker or adviser will do this for you. But do-it-yourselfers most often just tell the broker to sell enough shares to raise a given dollar amount. Then they usually rely on what's called the "average cost" method to figure their capital gain or loss. It's much easier, but it can be costly. Here's why:
Suppose you put $10,000 into Fidelity Magellan Fund at yearend every year since 1992. After paying the 3% sales charge, and assuming you did not reinvest any dividends or distributions, you would have accumulated a total of 1,097 shares purchased in 10 separate lots.
Next, let's say you want to get $50,000 in cash out of your holdings. Most people would simply ask Fidelity to redeem shares worth that much, which, at Magellan's net asset value on Apr. 30 ($96.03), would have been 520.7 shares. With an average cost of $91.19 a share, you would realize a gain of $2,521. At the 20% capital-gains rate, you would owe Washington $504.
But what if you asked Fidelity to sell specific lots of shares you bought in the years when Magellan's (FMAGX) price was high? To clear $50,000, you could optimize your tax situation by selling most of the shares you bought in 1995, plus all from 1997 to 2001. Instead of a gain, you would realize a capital loss of $8,261. And instead of owing tax, you could use the loss to offset capital gains from other assets. Or you could use up to $3,000 of the loss per year to lower your ordinary income. If you pay tax at the 35% rate, that could cut your first-year taxes by up to $1,050.
More investors don't use specific-share ID not only because they're daunted by finding their cost in what could be dozens of tax lots (Fidelity says its clients average 17 lots per fund), but also because most fund companies offer little help. The IRS requires documentation that you picked specific shares before the sale. In practice, that often means fund companies tell investors to make their specific-share sales requests in writing. So much for a do-it-yourself cybertrade.
For stocks, Fidelity has offered online sales by tax lot since November, 2000. It caught on: Specific-share ID sales jumped over 40% in December, 2001, over December, 2000. The other day, I watched a demonstration of Fidelity's new service for fund shares and then used a test account. There are many more features than I can describe here. But I came away impressed by its consideration of clients' needs (the database has tax lots back to 1987) and how clearly it explains so muddy a topic. It's a true leap ahead of the online pack.
Would I move a bunch of assets to Fidelity for this reason alone? Not tomorrow. But I am trusting in competition to drive Fidelity's rivals in this direction. Schwab and a few other firms say they are developing similar tools. I say, hurry up.
Corrections and Clarifications
Getty Images and CNN. The correct photo of Sullivan appears at left. In ``Fidelity's help for mutual-fund investors'' (BusinessWeek Investor, May 27), we incorrectly reported that Charles Schwab offers some clients an online service allowing them to trade mutual-fund shares by individual tax lots. Schwab expects this service to be introduced in 2003.
By Robert Barker