Financial planning, and especially tax planning, is loaded with jargon. But if you don’t understand the language, you wont be able to apply the tax rules to your advantage. In the long run, you will end up paying more tax and having less money in your pocket.
The term “cost basis” simply refers to the amount you paid for a particular stock, mutual fund or other investment. It’s adjusted for stock splits, reinvested dividends or interest, or returns of capital that may have occurred while you owned the investment.
For a simple example, if you made a one-time purchase of a stock for $10 and the stock never paid a dividend or had a split, your cost basis equals what you paid for it, $10 in this case. That’s about as simple as it gets. However, calculating the cost basis on stocks or mutual funds you own is rarely as simple as that.
A tricky calculation
If you have owned the same mutual fund or stock for many years, correctly calculating your cost basis can be challenging.
You may not know the original price you paid for your stock. Stocks can also have multiple splits or even reverse splits making your cost basis calculation more complicated. If you reinvested your dividends or made multiple purchases of the same stock, that will affect your cost basis as well.
Mutual fund cost basis can be even tougher to calculate. Mutual funds often have reinvested dividends and capital gains. With a mutual fund you are also more likely to have been making monthly contributions over many years. In some cases your mutual fund may have merged into another fund.
Fortunately, mutual fund companies and brokerage firms are required to track your cost basis these days. So determining your basis can be as easy as looking for it on your statement or asking your investment company for this information. The exception would be stocks that you purchased before January 1, 2011 and mutual funds purchased prior to January 1, 2012. That’s when the new cost basis reporting rules went into effect.
Why you need this information.
Your cost basis determines any taxable gain or loss you have incurred. The amount of your gain (or loss) is the difference between your cost basis and the price you get when you sell your stock or mutual fund.
That $10 stock I mentioned above? If it’s worth $50 when you sell it, you pay tax on $40 per share – the difference between the cost basis and the selling price. For most investors taxes on capital gains are 15%, but those in higher incomes can pay much more. Taxpayers in the lowest brackets may pay no Federal income tax on capital gains.
Sometimes investments lose money. If you sell the $10 stock for only $2, then you have a loss of $8 per share that you can write off against other taxable gains or up to $3,000 of personal income when you file your Federal income taxes. These losses reduce the total amount of tax you owe. Often investors will sell investments that have losses to offset taxes they may owe on other investments.
Pouring salt on the tax wound
Sometimes you may owe tax on your mutual fund investments even when you have had no taxable gains or have even experienced losses. In extreme cases owning a mutual fund for as little as one day could result in a taxable event.
Mutual funds are a collection of different stocks and other investments. Sometimes the fund manager will sell a stock that has a taxable gain. Assuming there are no capital losses to offset the capital gains from the stock sale, the taxes due on that sale are passed on to the shareholders of the mutual fund. This can be true even if you have never sold a share of your fund and even if you owned the fund, in some cases, for as little as one day.
How can this be?
Mutual funds tally up their gains and losses throughout the year. At the end of the year, typically November or December, all the people who own that fund on a specific day will be assessed any capital gains taxes due on the net gains of stocks sold within their portfolio. Even if you have only owned this fund for a day or have seen a decline in the price of your mutual fund shares, you may receive a taxable capital gain distribution.
Most of the time this isn’t a big problem, but if you are buying a mutual fund in a taxable account you may want to be aware of any possible capital gain and dividend distributions, and when they will occur, before you place your trade.
If you have a low cost basis in a stock or own a mutual fund that has experienced significant capital gains, there are some strategies you can use to minimize or even eliminate the taxes you will owe on these gains.
In my next post, I will tell you how.