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In a previous article, “Cost-Basis Reporting,” Lord Abbett explained the upcoming cost-basis reporting changes. This Q&A specifically focuses on Lord Abbett shareholders’ cost-basis options.
Q. What is a cost-basis method?
A. A cost-basis method is a systematic approach for ordering shares to be sold that were purchased at different times and at different prices. The order of the shares is used to determine which shares are sold first. A cost-basis method is also referred to as a tax lot relief methodology.
Q. What is a tax lot?
A. A tax lot is created whenever additional shares of a fund are purchased. Dividends reinvested are also considered purchases and, therefore, create a new tax lot. For example, if you purchased a mutual fund and elected to reinvest monthly dividends, you will have 25 tax lots after two years (the original purchase plus 24 dividend reinvestments). Each of these tax lots were purchased on different dates and at prices that may also be different.
Q. How does the cost-basis method impact a shareholder’s tax liability?
A. As described above, tax lots will have different purchase dates and prices. The order in which these lots are to be sold is based upon the cost-basis method used. Different methods may produce a different order of shares to be sold. Because lots have different purchase prices and dates the gain or loss and associated holding period (long or short term) may be different depending on the cost-basis method used.
Q. Why is the holding period important?
A. The maximum federal income tax rate on securities sold that were held longer than one year (long-term gain) generally is lower than the maximum federal income tax rate on securities held for one year or less (short-term gain). For example, if a shareholder purchased 100 shares at $10.00 per share on January 31, 2012, and another 100 shares for the same price, $10.00 per share, on June 31, 2012, both tax lots have the same cost basis ($10.00 per share), but different purchase dates. If this shareholder sells 100 shares on March 15, 2013, for $12.00 per share, his tax liability will vary depending on the lot that was sold. Assuming the January 31, 2012, lot was sold, the resulting long-term gain would be $200.00 (100 shares multiplied by the difference is the sale price of $12.00 per share and the cost basis of $10.00 per share). Assuming a long-term capital gain rate of 15%, the shareholder’s liability is $30 if the first lot is sold. If instead the second lot is sold, the gain will still be $200, because both lots were purchased at the same price; however, the gain will be considered short term. Assuming a short-term capital gain tax rate of 35%, the shareholder’s tax liability will be $70. In this scenario, choosing the first lot would produce a smaller tax liability.
Q. Why is the purchase price important?
A. The cost basis of a tax lot is determined by its purchase price adjusted by various tax items, including wash sales and returns of capital. To the extent a shareholder holds multiple lots with a different cost basis, each lot will produce a different gain or loss and potential tax liability (assuming the same sale price and holding period—long or short term).
Q. Which cost-basis methods can a shareholder choose?
A. Lord Abbett will be supporting six different cost-basis methods. In addition, a shareholder will have the ability to specifically select the lots that he wishes to sell instead of using one of the cost-basis methods. The following is a list of all methods available and a brief description of each:
Q. What is a fund’s default cost-basis method?
A. A fund’s default cost-basis method is average cost.
Q. Why would a fund choose average cost as its default method?
A. As a service to our shareholders, Lord Abbett has been supplying cost-basis information on shares purchased prior to January 1, 2012, to eligible accounts using the average cost-basis method. In order to maintain consistency, Lord Abbett has chosen average cost as the default method for shares purchased after January 1, 2012.
Q. Which method is best?
A. Each shareholder’s tax situation may be different; therefore, the “best” method for one shareholder may not be the best for another. A shareholder may want to discuss his personal tax situation with his advisor prior to selecting a method.
Q. How does a shareholder make a cost-basis election?
A. On November 15, 2011, Lord Abbett will start accepting cost-basis election for shares purchased after January 1, 2012. A shareholder’s election can be made online by visiting www.lordabbett.com or by contacting us at 800-821-5129.
Q. Can a shareholder elect a method to be used on shares purchased prior to January 1, 2012 (“noncovered shares”)?
A. Lord Abbett does not intend to change the approach on reporting noncovered shares. Lord Abbett will continue to supply average cost-basis information on noncovered shares to eligible account holders. Lord Abbett will not supply shareholders with cost-basis information using a method other than average cost on noncovered shares. A shareholder is not required to use the average cost-basis information on noncovered shares, and it will not be reported to the IRS.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.