Will Help Investors Adjust Gains, Minimize Taxes

Mutual fund companies tend to enhance services that are geared toward buying their funds more often than they enhance services for selling them. But Fidelity Investments is poised to do the latter.

By the end of June, the Boston-based firm will offer a new record-keeping service that will enable investors to adjust their capital gains taxes by pinpointing shares bought at specific times, according to James Griffin, a spokesman for Fidelity.

The firm will soon report to investors all of the different lots of shares they have purchased at different times and at what price. When investors want to redeem a certain number of shares they will be able to choose which shares to sell. That is, they can choose to sell shares that were purchased at higher or lower prices. And that can make a difference when reporting gains and losses to the Internal Revenue Service.

As it stands now, when investors want to sell shares of a fund that they have purchased over time, fund firms take into account all of the prices at which shares were purchased and come up with an average cost basis for investors to use when reporting to the IRS.

If, for example, an investor bought a fund at $5 per share one day and $15 another, the average cost basis would be $10. And if the net asset value was $20 when the investor finally redeemed shares, the investor would likely pay capital gains taxes assuming a $10 per share gain.

But if an investor is looking to maximize gains, it might make more sense to sell only the shares bought at $5. That's what Fidelity is looking to make it easier for investors to do.

"It sounds great because mutual funds make investing easy in pretty much every way except taxes," said Russ Kinnel, a mutual fund analyst at Morningstar of Chicago. "Investors often have lots of different price points, and with Congress taxing investors in goofy ways with regard to capital gains, being able to select which shares to sell can be a valuable service."

The new service will keep track of up to 150 lots of shares that investors can view when looking at their account online, Griffin said. Fidelity will provide the service, not only for its funds, but for the additional 4,500 funds offered through the firm's supermarket.

Investors will also be able to input their tax objectives and receive their best options for redeeming shares. Then investors will be able to sell the specific shares online while realizing gains or losses based on actual, not average, purchase prices.

"We're able to implement this because of the sophisticated record-keeping system we've developed," said Griffin. "It's been a reasonably long project to do, but we thought it was important for investors."

Griffin said that Fidelity is the first mutual fund company to offer such a service for funds. The firm initially rolled out a similar tool for individual equity securities in the fall of 2000. The positive feedback that Fidelity received from its brokerage clients is what prompted the company to expand the service to its mutual fund clients, Griffin said.

Who Will Use It?

While the service can be very useful, not everyone thinks investors are going to use it given its somewhat complicated nature. Also, while some investors constantly buy shares over time, most don't, which makes the service unimportant for them, said Ric Edelman, chairman of Edelman Financial Services, a financial advisory firm in Fairfax, Va.

"I don't think that a lot of consumers will take advantage of it," Edelman said. "Most mutual fund investors invest in one lump sum and draw money out in one sum. Many don't liquidate their holdings incrementally and so they don't need to worry about lot transactions. Still, there's a lot who could take advantage of it and should take advantage of it. It can be very helpful."

One reason that many investors won't care about the new service is because most financial advisers already do that sort of record-keeping for their clients, Edelman said. As it stands now, investors can sell specific shares at virtually any fund firm, he said. The only catch is that they have to maintain fairly complex records to do it and then send a letter to the fund company telling them which shares they want to sell. While financial advisers often go through the trouble of doing that, investors who deal directly with fund companies generally don't, Kinnel said.

"It's definitely going to be more advantageous for someone who is buying funds themselves," Kinnel said. "But this is an area where fund companies can really do more to track what people's cost basis is and make it more accessible."

IRS Requirements

One of the drawbacks regarding selling specific shares versus on an average cost basis is that the Internal Revenue Service requires that investors use the same average cost basis methodology all of the time, Griffin said. So once an investor sells specific shares of a fund, he or she has to continue to sell that way until all of their shares are sold.

That is true only on a fund-by-fund basis, however. In other words, an investor can sell shares in one way in one fund, and another way in another fund, but can't switch within each fund. Investors can, however, petition the IRS to be allowed to switch methodologies.

Therefore, investors who own shares in a fund and have sold some of them in the past on an average cost basis generally will not be able to take advantage of Fidelity's new tool for that fund, Griffin said. However, as investors add new positions, Fidelity believes the tool will be utilized more over time, if not right away, he said.

When a fund firm enhances selling practices, it must think about how the changes will affect active traders. Like many firms, Fidelity has taken steps to deter market timers from jumping in and out of funds, and the new service will not cater to active traders, according to Griffin.

"This is not an active trading issue, whatsoever," Griffin said. "It's an issue of offering the best possible services to customers when they make the decision to sell. Our investors are still long-term investors. But they should be given the options to sell in the most tax-appropriate manner."

When the service becomes available by the end of this quarter, Fidelity will likely put information about it on its Web site in addition to a formal press release, Griffin said. The firm has not yet determined what other customer communications it will engage in, if any. Because of the sophisticated nature of the issue, the Web site will likely include some educational content on how to use the service and what advantages it may have for individual investors, Griffin added.

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