This is summarized information for general discussion purposes only. For specific situations, seek a tax professional.
Your brokerage account is now recording cost basis for taxation with your accounts. The law has been phased in but for my accounts the brokerage firm has incorporated cost basis onto all of my stocks, even those that were purchased prior to the 2011 deadline for reporting.
In the past, when you sold a stock, they only reported the proceeds, not the costs, so you couldn’t automatically determine the gains or losses on the stock. In these instances you had to find the basis for your stock in old records or tracking it off line in another system (like Quicken or a spreadsheet).
You could guess where you were likely to have a gain or loss on a particular stock, but you couldn’t thoroughly investigate various strategies without doing a lot of work. For instance, you want to know the following:
- any short term or long term gains that you’ve already “realized” so far during the year (i.e. it already happened when you sold the stock)
- To calculate this you need the sales price and the cost basis for that stock, as well as the duration for how long you’ve held the stock, in order to determine if it is a “short term” or “long term” gain or loss (12 months is the cutoff)
Once you have all of the basis determinations, you need to figure out what to do with it. In general, you don’t want to have short term gains which are taxed as ordinary income (up to 39% for a high tax bracket investor, but much smaller or negligible for these trust funds) and you want to move gains to long term and offset them with losses to the greatest extent possible. Here is an example I borrowed from this web site:
For tax-reporting purposes, the short-term gains and losses (those made in one year or less) are first netted against each other for the tax year; then long-term gains and losses (those made in more than one year) are netted; and finally the remaining outcomes are combined together. So, a net short-term loss of $10,000 can be applied against a net long-term gain of $5,000 for a remaining short-term loss of $5,000 [-$10,000 + $5000 = -$5000]. In any given year, there is no limit on the amount of capital losses that can offset capital gains. However, only a maximum of $3,000 net loss can be deducted from ordinary income ($1,500 per person if married filing separately); any excess loss may be carried forward into future tax years. The carry-forward loss must maintain its definition as either a short- or long-term loss.
Maybe this isn’t the greatest example. The goal is to have 1) no short term gains left over 2) if you’ve netted all your gains out, find losses to offset up to $3000 of ordinary income (once again, these trust funds are for minors or adults in or near college with limited ordinary income, so the $3000 offset doesn’t usually apply to them).
So how does having this additional cost basis information help you with your decision? You can “fill in the pieces” of your tax strategy by just viewing the net position of your stocks per your broker. For instance, if you have a net short term gain going into year end of $5000 (across all your transactions for the year to date), and you see a number of stocks with a combined short term loss of $5000 or more, you can sell those stock sin order to offset the gain, and avoid paying some taxes. In general the ideal plan is to sell more losses than gains so that you can meet the $3000 “losses against ordinary income” threshold, so the ideal would be $8000 or so in losses (assuming $5000 in gains).
Not discussed in the example are the “basis” for cost reporting; you can choose a number of basis for a stock including FIFO and specific lots; there are also new, advanced strategies that can also be employed to select lots in order to achieve maximum or minimum taxes. For the purposes of this trust fund discussion we are assuming that you’d sell all of a specific stock.
You don’t want to make “tax strategies” drive your “stock planning strategies”, but it certainly makes sense to consider taxation in your buy / sell planning for stocks. If you sell a stock (for instance to incur a loss in order to offset a gain on a previously executed deal), then you can’t re-buy it for 30 days (the “wash” rule). However, you can buy different stocks or ETF’s that accomplish the same economic goals in most instances.
In a perfect world, we would continually “step up” the basis of the portfolio for each fund by selling winners and losers in a way that offsets each other so that when the portfolio finally is liquidated (to buy a house, for instance), there is a minimum capital gain on the total portfolio. To push it a little further, sales should be made even if they incur gains until they hit the “kiddie” tax limits and start to get taxed at higher rates.
The difficulty with this approach is that you don’t want to sell stocks that are rising and I don’t want to follow losers too far down (I want to sell by the 20% loss mark, although that isn’t a firm rule). We do try to be cognizant of this strategy longer term, though.
In general, the fact that brokerage accounts are now including cost basis makes tax planning easier to do. This is generally positive for the average investor.