Mutual funds are like most any other investment as far as the Internal Revenue Service (IRS) is concerned. That is, if an investor realizes a gain on the purchase of a mutual fund, that gain must be reported as income and the investor must pay mutual fund taxes. In finance, investment income is referred to as a capital gain. The IRS uses this as the basis for assessing the amount investors must pay for mutual fund taxes.
While mutual funds are a lot like traditional stock investments, they are a little different in how they operate. For instance, an investor owns shares of stock in a company, but he or she own units of a mutual fund. For this reason, the IRS gives special consideration for assessing the taxes due on mutual fund gains. While the calculation is easy, it is not intuitive.
In order to determine mutual fund taxes the investor must determine the original price of the investment and the current price of the investment. The average cost of the investment is referred to as the cost basis. It represents the average cost of the mutual fund after adjustments for stock splits or other distributions from the fund are made.
As an example, if a mutual fund investor owns 100 units of a fund purchased at a cost of $10 U.S. Dollars (USD) per stock, the total cost of the investment is $1,000 USD. If the fund pays out a capital distribution or $.60 USD per unit the investor is due $60 USD. The $60 USD is then reinvested back into the fund.
In order to calculate the number of units $60 USD buys in the fund, the investor needs to know the current value of the mutual fund units. If the current value of one unit of the fund has increased in value to $12 USD, the investor can purchase 5 additional units of the mutual fund for a total of $60 USD. Now, instead of owning 100 units, the investor owns 105 units of the mutual fund.
The new cost basis is determined by dividing the total cost of the units by the number of units the mutual fund investor owns. Adding the original cost of the units to the value of the units purchased gives a total cost of $1,060 USD. $1,060 USD divided by 105 units is $10.10 USD which is the new cost basis for one unit in the mutual fund. The IRS expects mutual fund investors to pay mutual fund taxes on any gain in value over and above this new cost basis for one mutual fund unit. The exact amount paid depends on the investor's income and total market gain.