Many of you invest in taxable (nonretirement) accounts in addition to investing in your 401k or IRAs. For those accounts there are new tax rules this year that you have to follow. These rules pertain to how you report gains and losses. Getting this right can potentially save you thousands of dollars in taxes.
It’s April again. Spring arrives, baseball season begins, and my wallet feels lighter after paying my “fair share” of taxes. There is some consolation this year, however. You get two extra days to file your income tax return since April 15th falls on a Sunday. You also get a reprieve on Monday April 16th because it’s Emancipation Day in DC. How ironic is that?
Many of you invest in taxable (nonretirement) accounts in addition to investing in your 401k or IRAs. For those accounts there are new tax rules this year that you have to follow. These rules pertain to how you report gains and losses. Getting this right can potentially save you thousands of dollars in taxes so it’s worth spending some time discussing this.
The new IRS reporting rules
Before 2011, if you sold investments in a taxable account, you’d get a 1099 form from your brokerage firm listing the net proceeds you received from the sale of the investment – whether a mutual fund or individual stock. Sales were directly reported to the IRS, but what you bought these investments for was not reported. It was up to you to determine your gains and losses and report these gains or losses on Schedule D of your income tax return.
The game has changed. Now all buy trades are reported directly to the IRS along with sell trades. This means you better be sure you’re matching up your sell transactions with your buy transactions and reporting your gain/losses accurately. Otherwise get ready for some potentially nasty IRS letters.
Like any tax law, this gets sticky. The problem is that if you bought stocks or mutual funds before 2011, those transactions are still not reported to the IRS. It’s only the buy trades after 1/1/2011 (for stocks) and buy trades after 1/1/2012 (for mutual funds) that are reported.
So your new 1099 forms from your brokerage accounts will divide the investments into “noncovered” investments – those investments whose buy transactions were not reported to the IRS – and “covered” investments which are investments whose buy transactions are reported to the IRS.
Now you’ve got a big headache. Suppose you bought some shares of a stock or fund in 2005, 2006, 2009, 2011, and 2012 and you sell a portion of those shares. The proceeds from the sale will be reported to the IRS, but you have to determine whether the shares came from the noncovered shares or the covered shares. And don’t forget reinvested dividends. Those are included in these calculations.
Take advantage of cost basis methods
That gets us to the concept of cost basis, which is simply the net investment you made into a particular stock or fund. Suppose you bought 100 shares of stock for $50 per share and paid a $25 trading commission. Your cost basis is 100 X $50 = $5,000 plus $25 = $5,025. If you later sell all of these shares for $100 again paying a $25 commission, your proceeds are 100 x $100 = $10,000 - $25 = $9,975. Your gain from this sale is $9,975 - $5,025 = $4,950.
Easy, right? I wish.
The complexity rapidly increases when you’ve got multiple transactions in a taxable account over time. Let’s look at an example. Suppose you made the transactions above in a mutual fund over the past few years.
In this example the last two transactions would be reported directly to the IRS but the first three would not since they are noncovered transactions. What gain do you have to report on Schedule D of your income tax return?
That depends on what method of cost basis reporting you’re going to do. There are more cost basis reporting methods now then there were a few years ago. While I don’t have the space to cover all of them, let’s take a look at two of them to see how you can save a ton of money and reduce your tax bill.
FIFO & HIFO
One method is the First In, First Out (FIFO) method. With FIFO, the shares sold are automatically matched to the earliest shares you bought. So the sale of 1000 shares on 8/10/12 would be matched with the buy shares on 2/1/09. This means your total gain is $30,000 ($50,000 in proceeds minus 1000 x $20 in cost basis). With the capital gains tax at 15% and assuming a state income tax of 5%, you’d owe about $6,000 in taxes on the sale.
But there’s another cost basis reporting method you can use: Highest In, First Out (HIFO). In this method the sale of shares is matched to the shares bought for the highest share price. So the sale of 1000 shares on 8/10/12 would be matched with the buy shares on 1/7/12, resulting in a gain of $0 and a tax liability of $0. In this example, using the HIFO method saved you $6,000 in taxes.
Don’t ignore the minutiae
To make matters worse there are other factors that come into play here. If you’ve been reinvesting dividends, each dividend reinvestment adds another cost basis lot to the pool. If you’ve been in an investment for many years and have been reinvesting dividends all along, you could potentially need to keep track of dozens of cost basis lots.
Anytime you sell partial shares, you then need to readjust your cost basis in the remaining shares that you matched up the sale with. If you sell shares for a loss, you need to figure out which costs basis lot you want to use.
Finally, for gains, the tax rates for short term gains (gains on shares held less than one year) are higher than long term gains. So it’s possible that you could pay more tax by selling short term shares for a lower gain than by selling long term shares that have a higher gain.
Are we having fun yet?
What you need to do
Unfortunately, many CPAs simply report the proceeds from the sale and then expect you to tell them what you bought these investments for and the cost basis. A good fee-only investment advisor should do this for you, but most simply don’t take the time to figure out how you can reduce your tax bill by using the right cost basis methods, readjusting cost basis after the sale, and considering long or short term gains.
So here’s what I suggest:
1. Create a spreadsheet detailing all buy and sell transactions and calculating net cost basis for each of those lots. Do this for all investments in your taxable accounts.
2. Change the cost basis reporting method you use with the custodian that holds your account. HIFO is generally better, but there are others that may be more beneficial to you.
3. Breakdown your cost basis lots into noncovered and covered shares
4. Before you sell, think about which cost basis lot may result in your lowest tax liability, taking into consideration short vs long term gains. Then readjust your cost basis for the original shares you bought if you sold only part of the original lot.
Setu Mazumdar, MD practices EM and he is the president of Lotus Wealth Solutions in Atlanta, GA www.lotuswealthsolutions.com