Dangerous New Rules if You Use Average Cost Accounting for Mutual Funds

with No Comments


If you use the average cost method for mutual fund cost basis, don’t. You have until the end of the year to switch.

Krisan Marotta (my wife) wrote an article describing the new rules in “Are you ready for bifurcation?” in which she explained:

With the new IRS tax reporting regulations, average cost positions will be bifurcated. Thanks to government regulation, covered and uncovered shares will now maintain a separate average unit cost which require manual data entry in PortfolioCenter to maintain accurate cost basis data for both unrealized and realized gains and losses.

Here’s the gist: The new rules that go into effect January split your mutual fund shares into two buckets: those purchased before January 1, 2012 (which are “not covered” by the legislation) and those purchased after the January 1, 2012 (which are “covered” by the legislation). Each bucket must have its own average cost, and and the legislation requires you to sell shares from the uncovered bucket first until they are exhausted.

That means that you will have to sell the bucket with the lowest cost basis and therefore the highest gain first. This is NOT what you want to do for tax management. There are several methods for cost basis calculations.

We use the Tax Lot Optimizer as our default and then override the few decisions that it gets wrong (such as gifting or purposefully realizing capital gains in the zero percent capital gains tax bracket). There are cases where being able to pick the exact trade lots you want to sell saves tens of thousands of dollars in capital gains taxes by postponing them until a future year when you are in a zero percent capital gains tax bracket or until your heirs get a step up in cost basis.

We highly recommend Krisan’s services to any investment advisor. And not just because she’s my wife.

Krisan Marotta of Krisan’s BackOffice, Inc. invented outsourcing the back office for investment managers in 1992 and has been providing comprehensive, personalized PortfolioCenter and Centerpiece data management ever since. Our firm is one of her clients, and I have to say that outsourcing the performance reporting and data management to her has been one of the best decisions both for our firm and for our clients. She brings twenty years of experience with dozens of managers. And as a Phi Beta Kappa, Stanford graduate “With Distinction” you know she knows her way around the most complex financial transactions.

Her services have allowed us to focus less on the data and more on serving our clients and building our business.

Follow David John Marotta:

President, CFP®, AIF®, AAMS®

David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.