If there is one certainty in life, it’s taxes – Uncle Sam has to have his share. And when it comes to investing, the Feds, as well as state and local governments, have their hands in many places. One of them happens to be when it comes to capital gains.
Capital gains taxes can burn on a variety of fronts. From holding periods to various corporate events, the buying and selling of investments can be tricky. And one wrong move can impact taxes in a big way. But investors do have some tools at their disposal.
And one of them is understanding their “cost basis.”
While a simple concept, keeping track of a portfolio’s cost basis can help reduce, defer and even potentially eliminate taxes all together. It’s one of the best tools we have to help keep Uncle Sam at bay.
Click here to explore the portfolio management channel and learn more about different concepts.
Basics of Cost Basis
At its core, the cost basis is pretty easy to understand. It’s basically the initial value or purchase price of an asset or investment. So, if you buy 10 shares of XYZ stock at $10 per share, your cost basis for the lot of stock would be $10 per share or $100 total. This information is valuable and required if you ever need to sell that lot of stock. When it comes to capital gains, taxes are owed on the difference between this original cost basis price and what you sell the asset for.
That’s really the basics. The problem is, a variety of things can impact that cost basis and change it – both initially and over time.
For example, initially that cost basis includes any brokerage fees, sales loads on mutual funds, and any other trading costs acquired during purchase. These help to push the cost basis up and reduce taxes later on. However, with the growth of free trading, zero-load mutual funds and overall lower initial investment costs, the effect is starting to dwindle.
Use the Dividend Screener to find the security that meet your investment criteria.
At the same time, dividend investors need to understand their cost basis because various corporate actions can impact this initial purchase price over time. Actions such as mergers, stock splits and dividend payments can affect the cost basis. This is especially true if you reinvest those dividend payments. These reinvested dividends can create a plethora of stocks with different initial bases.
Mutual fund and other asset class owners, such as master limited partnerships (MLPs), have a few other things to worry about when it comes to cost basis. For mutual funds, unrealized gains inside the mutual fund that have not been distributed to shareholders can shift cost basis around. MLP distributions themselves are tax-deferred by their structure, so instead, they reduce an investor’s cost basis until the asset is sold.
Taxes, Taxes, Taxes
Essentially, the changes in cost basis does one thing, and that’s either reduce or increase the amount of taxes you owe Uncle Sam. Given that short-term capital gains taxes can be as high as 39%, understanding your cost basis and how to minimize taxes is critical.
Luckily, starting in 2011, the government required brokerages and asset managers to keep track of cost basis for shareholders. If you bought your investments before that, you need to do some calculating on your own and check your statements.
That cost basis data on your brokerage statement is a wealth of information that can be used to help reduce your taxes. First, time of purchase should be considered. Older lots that have been held over a year qualify for the lower long-term gains rate. But even here, different lots can have different tax rates given the initial cost basis. Investors do have some choice to help reduce taxes further beyond short- vs. long-term gains. This comes down to method of sale, and there’s basically three ways to do that.
- First In, First Out (FIFO): This cost basis method is often the default for brokerages. Here, the method will sell the first/oldest shares you’ve purchased, which should ensure that you sell shares qualifying for the long-term capital gains rate depending on if you’ve held them for at least a year. However, using FIFO could also mean that you owe a lot in taxes depending how much the asset has appreciated since the initial investment.
- Specific Identification: This method allows you to specifically tell the brokerage firm which lot of stock to sell. By using the specific identification method, you have the most flexibility, and potentially the lowest tax liability. For example, if you have two lots of stock qualifying for the long-term rate and one has a much higher cost basis than the other, you’ll owe less in taxes on that lot. It may make sense to sell this lot and pay less in taxes today.
- Average Cost: Mutual fund investors have another way to determine cost basis which could help simplify the reinvestment of dividends and capital gains. The average cost method simply takes the average cost basis for all the shares of the fund you own and then multiplies it by the number of shares you’re selling. This smooths out the cost basis. For mutual funds, this can be important given that most investors’ dollars have a cost average of small amounts over time, and then reinvest distributions and fund dividends. However, you are able to use both FIFO and specific lot methods when it comes to mutual funds.
The real goal of using the different methods and your cost basis is to reduce taxes on sales of assets. By looking at your various initial costs, you can come up with a game plan for owing less taxes and even engage in strategies like tax-loss harvesting.
The Bottom Line
Uncle Sam gets his way. Taxes are a guarantee.
Understanding how your cost basis works for your investments can be a vital tool in order to reduce your taxes. By looking at your investment statements, selecting the right security lots and selling assets in a favorable manner, you can keep more of what you gained.
Be sure to check out our News section to keep track of the latest updates around income investing.
