How much did you make? Seems like an easy question to answer. If you don’t have an answer, the IRS can help. I can’t promise the IRS’s calculation would be to your benefit. The IRS assumes that all proceeds are gains. The IRS is happy to alleviate you of your hard-earned cash.
To properly answer this question, the first step is to figure out your “cost basis.” “Cost Basis”
seems more technical than it truly is. Cost basis is simply the amount you paid to purchase an asset. Say you bought 1000 shares of ABC stock for $10, your cost basis is $10,000. (1000 shares times the $10.) The gain (or loss) is the price you sold the asset minus the cost basis. It’s not a hard calculation, but knowing you could be dealing with the hard-nosed IRS introduces anxiety.
A simple example is easy enough. Complication accrues as stock splits occur and dividends are reinvested. The underlying calculation remains the same, yet the added lots (shares purchased at the same time with the same price) raise the anxiety bar.
Here’s what you need to know.
- Holding period: How long did you hold the investment?
- Less than 12 months, gains are considered short-term and mirror ordinary income tax rates.
- More than 12 months, gains are considered long-term with applicable long-term capital gains rates. An important distinction is long-term gains tax rates are lower than short-term gains rates.
- FIFO, Average Cost, Specific Shares.
Stocks, bonds, funds, and ETFs are often accumulated in different lots over a long time. You can account for those lots in different ways.
- FIFO (First In, First Out) simply means the oldest lots will be sold first. This is typically the default for exchange-traded or over-the-counter securities such as stocks, bonds, and ETFs.
- Average Cost means the cost is a running average of the purchased lots. This is the default for mutual funds as dividends are often reinvested, which can be numerous over the holding period.
- Specific Shares is exactly as it sounds, specifically identifying which lots to sell, gift, or transfer. This offers the best ability to select the highest cost shares (reducing the taxable gain) or lowest cost shares (to gift highly appreciated lots to someone else or a charity).
Keeping track of these lots can be onerous. Good thing we are in the 2020s and not in the 1970s. Nowadays, custodians offer this as part of their normal service menu. Yet, investors that hold certificated shares in a safe deposit box or in one’s closet will be held responsible to track, monitor, and report.
A few other points to maximize your tax management: capital gains can only be reduced by capital losses, or investments sold at a loss. Hence, realizing losses can reduce your capital gains tax. Further, losses in excess of gains can reduce your earnings by $3000 annually. Lastly, capital losses can be carried forward indefinitely until exhausted.
Cost basis basics are not difficult, but can be complicated. This is especially true for investments that you hold for a longer period or for those that you inherit or receive as gifts.. The best option is to let systems do the hard work while you collect the rewards.
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