If you own a mutual fund outside of a retirement plan, the rules for figuring out the taxes you need to pay can be tricky.

Mutual funds commonly pass through distributions, which can be ordinary income, dividend income, capital gains, tax-exempt interest or return of capital distributions.

• The income that is required to be reported as taxable income on your tax return will be reported to you on a Form 1099. Generally, dividends received by an individual shareholder from domestic and qualified foreign corporations are taxed at the same rates that apply to capital gains.
• If your mutual fund generates short-term capital gains and these are passed through to shareholders, they are treated as ordinary income, which can't be offset by capital losses.
• If you invest in a tax-exempt mutual fund, the fund can still generate capital gains and ordinary income. So all your distributions may not be tax exempt.
• When you redeem your shares, it is treated as the sale of a capital asset and is subject to capital gains tax treatment. So, you'll need to know your basis and your holding period.

IMPORTANT NOTE: Good records are essential in order to determine the basis and holding periods of mutual fund shares. So keep all the documents you get from the mutual fund as part of your tax records.

IMPORTANT NOTE: Many mutual fund companies and brokerage houses allow you to switch from one fund to another. For tax purposes, these transfers are considered redemptions and you may have capital gain or loss on the transfer.

See the Mutual Fund Shares worksheet, which you can use in keeping track of the basis and holding period for your mutual fund shares.

This worksheet should be completed for each mutual fund transaction. This will help you maintain the information you'll need to compute the basis of shares you sell. Remember, you still need to keep all your original documents to support the worksheet.

SUGGESTION: Some funds are more helpful than others when it comes to providing assistance in computing the basis in your mutual fund shares. The availability of this special service is one of the factors to be explored before investing in a fund.

If you have check writing privileges and your mutual fund is not a money market fund, you have some work to do every time you write a check. Each check you write against your non-money market mutual fund is treated as a redemption of shares, and you must compute capital gain or loss on the difference between the redemption price received and the basis in the shares.

Your holding period for shares purchased under an automatic reinvestment plan starts on the date the dividend is paid.

If you sell some of the shares in your mutual fund, but not all the shares, determining which shares have been sold can get tricky.

There are four basic methods for identifying which mutual fund shares are being sold:

1. First in, first out—Shares purchased first are considered sold first. If you can't use method 2 or don't make an election under methods 3 or 4, you must use this method.
2. Specific share identification—If you can identify which shares you sold, you can use the basis and holding period for those shares to determine gain or loss. To use this method, you must specify to your broker the particular share to be sold and must receive confirmation in writing from the broker.
3. Average basis method - single category—The total basis of all your shares is accumulated and divided by the number of the shares held to determine an average basis. Holding period is then determined on a first in, first out basis.
4. Average basis method - double category—Your shares are divided into two categories, those held more than one year and those consisting of shares held one year or less. Then you can pick the category that is being sold (long-term or short-term).

Methods 3 and 4 can only be used if you make an election on your tax return for the first year you want the election to apply. If you use one of the average basis methods, many funds will do the averaging for you.

The above rules are complex, so if you need help, call your tax professional.

IMPORTANT NOTE: Mutual funds are required to distribute income and capital gains to shareholders. It is generally not advisable to invest in a fund just before it makes a distribution. If you do, you'll end up paying tax on income that really amounts to a return of the investment you just made. Your best bet: Call the fund to determine the next distribution date. Plan to make your investment just after that date.

SUGGESTION: When you decide to sell shares in a mutual fund, you can save taxes by selling before the distribution date. By doing so, you may be able to realize capital gain rather than ordinary income (if income other than qualified dividends is passed through).

You can call the IRS to order Publication #550, Investment Income and Expenses. The number is 1-800-TAX-FORM, or go to the IRS Web site at www.IRS.gov.

Computing Your Basis in a Mutual Fund

Your basis in a mutual fund generally includes the amount originally invested, plus:

1. any dividends that have been reinvested
2. undistributed capital gains (your mutual fund will provide you with this information)

and minus:

1. non-dividend distributions (your mutual fund will provide you with this information)
2. The basis of mutual funds shares you've sold

Your basis cannot be reduced below zero.