Cost basis is an often unloved but certainly important piece of information in managing investment decisions in non-retirement accounts. With the upcoming tax changes scheduled for 2013, however, cost basis and capital gains or losses could play a more important role than usual in your decisions before the end of the year.
Your cost basis is the total amount you have invested in any particular position or asset. In the case of a stock, bond or mutual fund, the cost basis is comprised of not only your initial investment but any additional purchase of new shares – whether they come via reinvested dividends or income or are simply new money invested.
Cost basis shouldn’t be overlooked because the basis can be an important variable in your after-tax returns. Being tax efficient can help you protect more of your gains.
In 2013 the long-term capital gains tax is scheduled to rise from 15% to 20% of the gain for most taxpayers and as high as 23.8% of the gain for high income earners. The current rate has been in place since May 2003. Although this tax will rise by a third, even the 20% rate is historically low. The average long-term capital gains tax since 1942 is 27.55%.
Considering the following scenarios may help you make tax-wise decisions about your investments before year end.
GO AHEAD AND SELL A WINNER
Generally, deferring taxable events as long as possible is preferable. But this year, realizing gains and paying the capital gains tax at the 15% rate, rather than a higher tax later, could effectively increase your after-tax return on your investment. Where gains are concerned, there is no rule that disallows you from repurchasing the same asset that was sold. Or, perhaps more appropriate, you can realize the gain by selling the asset and use the proceeds to further diversify your portfolio, managing risk.
CONSIDER HOLDING ON TO LOSERS (if the asset still fits your investment objective)
Realizing losses by selling positions that have declined below the cost basis is a common year-end task. But you may want to think twice about this strategy. One reason is that losses will be more valuable when used to offset capital gains in the future at higher tax rates.
Another less obvious reason is that while you may receive tax benefit by selling at a loss now, it’s possible that the benefit could be more than offset by future capital gains taxes that are higher. Here’s an example. Consider an investment with a $20,000 cost basis that declines to $15,000. You sell the position and realize a loss of $5,000 before December 31, 2012. You reinvest the proceeds for a new cost basis of $15,000, not the original $20,000. The reinvested money rises to $30,000, doubling your money, and you sell. Because of this tax increase, you would owe more in capital gains tax than if you had just held the initial position with a $20,000 basis and waited for it to grow to $30,000. The initial tax deduction of the $5,000 loss would be worth $750 assuming the 2012 15% capital gains rate. But the reinvested assets, growing from the lower cost basis would generate a higher future tax bill. Essentially, there would be an extra $5,000 of capital gain. With the future capital gains tax at 20%, the tax cost would be $1,000, a bigger drag on your after-tax return than the $750 tax deduction that was received upon selling the initial investment for a $5,000 loss.
NO TAXES ON CAPITAL GAINS FOR LOW INCOME EARNERS
If your taxable income happens to be under $70,700 (married filing jointly) or $35,350 (single taxpayer in 2012), you can sell investments with a long-term capital gain in 2012 and pay no tax. Next year, a 10% capital gains tax returns for individuals in the 15% tax bracket or lower. This may be most useful for people who have business losses or other causes for unusually low taxable income but they still have assets in a taxable investment account with gains.
TURN THE UNKNOWN INTO A GIFT
Many people have investments for which they do not know the cost basis. If it is not easy to compile an accurate historical basis for the holding, there is a simple solution with many benefits – gift it. If you donate the investment to a non-profit organization, you will receive a tax deduction for the date-of-gift market value and there is no need to determine what the basis is. You can receive a tax deduction for securities gifts up to 30% of your adjusted gross income. The charity receives the gift and does not have to pay a capital gains tax whenever it sells the position. If the position is of a size larger than you would comfortably gift normally, discuss funding a charitable gift annuity or other account that returns an income stream to you to supplement your retirement income.
DON’T DOUBLE PAY TAXES
Regardless of your situation, keeping track of cost basis is important so that you don’t unintentionally pay more tax than necessary. The most frequent problem investors face when determining their costs basis is not adding reinvested dividends or income to your initial purchase cost. This creates a form of double taxation. The reinvested income is taxed annually whether you reinvest it or not. If it is not included in growing the cost basis over time it is essentially taxed again as capital gain at the sale of the asset.
For many people who have held investments with reinvestment features over the years – or who have transferred a holding from a fund company to a brokerage or from one brokerage to another, keeping track of the cost basis can require a tedious search of old statements or trade confirmations.
All taxable mutual fund and brokerage account statements are now required to include cost basis. If your statement is missing information, the custodian of the account does not have complete records. You will need to go on a bit of a treasure hunt for the missing details. You should be sure to understand the basis before selling the position to make sure that it is accurately reported to the IRS by the custodian of the account.
Two other points are worth noting that may impact your decisions to sell investments and realize gains or losses. If you have a capital loss carryforward (losses beyond what you could deduct on your tax return in previous years) it may be more valuable to you to wait to next year to sell your winning investments to offset higher capital gains rates than this year.
And there is another way to gain tax efficiency and better after-tax returns that may be worth waiting for, if unpleasant to think about – your death. If you like a holding and it is a good fit for your investment objective long term, there is no need to get strategic about the capital gain. Assets held until death in taxable accounts receive a basis step-up to the value on the date of death. It’s a nice benefit to your heirs and serves as one instance where death and taxes are not actually linked as certainties in life.
Have you reviewed the cost basis of your holdings for accuracy?
Are there steps you can take to improve after-tax returns on your investments?
By Gary Brooks, CFP® – Brooks, Hughes & Jones – Partners in Wealth Management – Tacoma, WA
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