Knowing the cost basis on your house or your investment portfolio is critical to building your wealth in a tax efficient manner. Without managing the cost basis in your portfolio you may inadvertently increase your tax liability. These last six months we’ve encountered a large number of cost basis issues so I’d like to enhance your understanding of how cost basis can impact your wealth.
What is cost basis? When you look at your investment statements you’ll see a column that states the cost basis for that investment. Simply stated, cost basis is the cost you incurred for that security. In reality, cost basis is more than the original cost. In fact, many securities change their cost basis annually and in other specific situations.
First let’s make sure that we’re clear on the types of accounts that we’re talking about. If your investment portfolio only consists of tax-advantaged accounts (401K, pension or any IRA) you can safely ignore cost basis. In such accounts your tax liability is governed by Federal and State tax rules and not impacted by the cost basis rules discussed here. If, on the other hand, you have a taxable account (a trust, individual, or transfer on death (TOD)), every year your personal tax liability will be dependent on what is in that account and how it is managed.
Just about everyone knows that gain from the sales of a security is taxed (short-term rates if held less than 12 months and long-term rates if held longer). This taxable gain, as you can imagine, is the difference between the sale price and the cost basis. It is to our tax advantage to keep this difference low but it is a better investment when it grows far higher than the basis.
What you may not realize is that without buying/selling you may still incur 1099 dividend and capital gain distributions that are taxable. These are distributions that flow to the shareholders from funds when they earn and “realize” gain. For high earners these distributions can add an unreasonable annual tax burden because the current tax code not only taxes the gain but adds the gain to inflate the Adjusted Gross Income (AGI). After all, it is the level of the AGI that will determine the phase out deductions and if higher taxes apply. If possible high earners need to reduce funds that yield large distributions from their taxable portfolio.
Up until 2012 we were each responsible for tracking cost basis on our taxable accounts and reporting cost basis and gains for our investments. If you have no actual evidence of the cost basis then your basis is considered to be zero – maximizing your gain and therefore your taxes. Not something any tax payer would want. In 2012 funds were required to report basis relieving us of this task by creating what are known as “covered shares” (those purchased after 2012 and for which the brokerage firm has records) and non-covered shares (those for which the brokerage firm has no record or were purchased prior to 2012). We help you track, recreate and manage cost basis for portfolios under our management.
If you were diligent enough to read this far, I want to alert you to one very important role of cost basis. On the death of the original owner of a security current rules allow for the basis to be elevated to the market value on the day of death. This is called a step-up in basis. Why is this important? If those securities have appreciated in value, the advantage is substantial. The gain in the securities is wiped out so that inherited assets are received at current value without paying capital gain tax. This process of step-up must follow required steps and careful monitoring of cost basis information.
When managing a portfolio whose goal is to be inherited there is little advantage to reducing any gains to the portfolio, particularly if the current owner already is subject to high taxes. The opposite might be true if the owner has low taxable earnings and is still young since they would benefit from keeping the gain of the portfolio low and therefore available for near term purchases (with minimal tax implications in any one year).
Considering the effort in managing cost basis, why do I consider a taxable account essential to your portfolio? A taxable account has at least two practical advantages that other types of accounts can’t provide. One is that it is available for short-term goals (for withdrawals prior to age 59½). The other is that in a retirement portfolio it often provides a means to reduce taxes during retirement. For example, most retirees have social security and tax deferred accounts to fund retirement. Withdrawals from such tax-deferred accounts are treated as having a zero cost basis and taxed as regular income. Whereas assets withdrawn from a taxable account with the cost basis carefully managed should see a lower tax liability. A taxable account is a key part in planning how the portfolio will support your needs.
The real lesson here is that growth in a taxable account is a double edge sword. To avoid paying unnecessary taxes and take full advantage of the account, it needs to be managed and, moreover, requires that you provide your advisor with updates on your past taxes and current year tax plan. The key is to choose the right investments and to manage the cost basis based on your specific goals and tax situation.