If you own shares of a mutual fund you may be paying too much in taxes through a common pitfall that catches many investors. When you sell shares of a mutual fund you have to pay capital gains taxes. In the most simple transaction that is calculated using the following method:(sales proceeds – original purchase amount) * the capital gains tax rateBut life is usually a little more complicated than that. The above formula assumes you bought shares of the fund and held them, never having any additional purchases, sales, or reinvestments. In the above scenario, the “original purchase amount†is also known as your tax basis, or cost basis.In real life many investors choose to have their dividends and capital gains distributions reinvested in more shares of the fund. This is a great way to accumulate more shares of the fund. It’s also a potential tax pitfall if you don’t watch what you’re doing when you sell those shares.As those reinvestments occur they are essentially buying more shares for you with the distributions in lieu of your receiving cash. (Keep in mind, though, that you are taxed on the distributions as income in the year they occur. Because the income was credited to your account, it could have been paid out to you, and therefore is taxable in the year it is paid, regardless of whether you buy more shares with it or not.)What that means is that your tax basis increases, thereby adjusting the tax calculation you have to make when you calculate your capital gains tax upon sale of the shares. Your original purchase price is still part of the tax basis, but instead of having it stop there you also add the total amount of reinvested income. So if you bought shares for $1,000, and received reinvested dividends of $100, your adjusted tax basis is now $1,100.Then the formula then goes something like this:(sales proceeds – adjusted tax basis) * capital gains tax rateUsing the above example, let’s say you sold your shares for $1,500 for a long term capital gain at a rate of 20%.$1,500 - $1,100 = $400$400 * .20 = $80 capital gains taxSince your additional purchases (earned through reinvestment of income) increased your adjusted basis, the amount of net proceeds is less, thereby lowering your overall capital gains tax rate. If, however, you failed to take this into account you will have ended up paying tax on the reinvestment as income when received as well as paying capital gains taxes on it when the shares are liquidated.