[This post is written and copyrighted by FIRE Finance (http://firefinance.blogspot.com).]
We came across the article "Wrong investment basis could cause bigger tax bite" by Kay Bell at Bankrate. It has some important information about cost basis of our investments i.e. stocks and mutual funds and how we may end up paying the same tax twice to Uncle Sam. If you reinvest dividends and capital gains rather than take the earnings in cash, it is important that you understand the scenario clearly.
We revisit Kay's simple example to explain the above concept here.
"Generally, you subtract the price you paid for an asset from its sale price to arrive at your taxable basis. But, reinvested earnings affect basis.
Here's how it works: You bought 100 shares of a stock for $1,000 in 2003 and that year had dividends of $100 reinvested. In 2004, you got another $200 in dividends and capital gains distributions, again reinvested.
Tax law considers these reinvested earnings as paid to you even though you didn't actually have the cash in your hand. The Internal Revenue Service considers the earnings as being "constructively received" by you, meaning the money in your account belonged to you and you could have taken it out if you wished. These earnings are reported on Form 1099-DIV and you must pay taxes on the amounts in the years you receive them.
Last year, you sold all your stock for $1,500. Here's where your reinvested dividends can help reduce your taxable gains.
Take your $1,000 original purchase price and add the $300 that you reinvested -- and already paid tax on -- over the years. This gives you an adjusted cost basis of $1,300. This is the amount you subtract from your sale price of $1,500, meaning you have taxable gain of only $200 instead of $500.
If you don't account for reinvested distributions, you'll end up giving Uncle Sam tax money a second time when you sell.
And if you're looking to take advantage of a capital loss to reduce other gains, a wrong basis amount could cheat you out of the full benefit of that tax advantage.
For example, let's say in the scenario above you sold your stock for $800, thinking you'd use the capital loss to offset gains you made on another holding. However, you're not getting the best possible tax loss unless you take into account your reinvested earnings.
If you simply subtract your original investment of $1,000 from your sale proceeds of $800, you get a $200 loss. Your true loss is larger: you have to subtract the adjusted cost basis of $1300 from your sale price of $800. This will give you a capital loss of $500. That extra $300 in losses could make a difference in your final tax bill.
To make sure you don't overpay the IRS on your investment gains or lose out on a valuable tax-loss deduction, hang on to all your stock and fund account statements. "