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By
Sherrill St. Germain
March 2006
Q: What is meant by the "cost basis" of
my investments, and do I need to worry about it?
A: Most definitely yes, if:
- You own investments outside of retirement or other tax-deferred
accounts.
- You'd rather not pay more income tax than you owe.
- You'd prefer not to spend your Saturday doing the
accounting equivalent of an archaeological dig.
But let's back up a little…. What is
cost basis?
At its simplest, cost basis is the amount that you paid
for a particular investment. The reason that it matters
so much is that it is a major factor in determining your
gain or loss on that investment and the corresponding income
tax implications.
The concept is simple enough. Let's say you
bought 100 shares of HiTechCo, Inc., at $25 per share. Your
cost basis is $2500. A few years later, you sell your
shares for $4000, so your gain is $1500 ($4000 proceeds -
$2500 basis, ignoring commissions), and that would be the
amount subject to income tax.
However,
determining your cost basis can be more difficult under certain
circumstances. For example, let's
say you opt to reinvest dividends and capital gains paid
out by your investment, rather than having them paid to you
in cash. Each time you do that, you are essentially
buying more of that investment, which means your cost basis
goes up accordingly. Since this reinvestment is often
done several times per year and purchases are usually fairly
small, people tend to forget about this component of cost
basis, which can really add up after several years of holding
an investment. The end result? The dreaded overpayment
of taxes.
The good news is that, these days, most brokerage firms
track cost basis for you and proactively send you information
when you sell a security (or make it available all the time.) The
bad news is that cost basis on certain investments may not
be quite so readily available for one or a combination of
the following reasons.
- You
own long-held shares, perhaps even paper stock certificates,
for which good records were not kept.
- Shares
have changed hands, through gifting or inheritance, one
or more times.
- Statements
have been lost.
- Stocks
have split or reverse split.
- Mergers,
acquisitions, and/or spin-offs have happened.
- You've
changed brokers.
- They've changed computer systems.
The upshot: If you're fairly new to investing,
chances are good that your broker has all the cost basis
information you'll need, but it's not a bad idea
to double check. If not, you may save yourself some
serious time and/or money in the end by keeping track of
it yourself (or changing to a broker that does.) Finally,
if you're in the position of holding an investment
with incomplete or no records, check out this great article
from Smart Money, Figuring
Out Your Cost Basis When You've Lost the Statements, for
ideas on pulling this information together.
Additional Ideas and Resources:
- Bankrate.com: "Wrong
Investment Basis Could Cause Bigger Tax Bite"
- Before
you transfer an investment from one
brokerage to another (or ASAP after),
ask the original broker for the cost
basis at the time of transfer & keep
a record of it. (The new broker
may well maintain this data for you.)
- If
you are fortunate enough to receive an
investment as a gift, not to look a gift
horse in the mouth but... try to also
get the cost basis and/or transaction
history.
- When
disposing of financial records, proceed
with caution! While you'll certainly
want to avoid the "archaeological
dig" method of determining cost basis, it's
best to leave yourself the option. (For more on keeping
good financial records, check out Organizing
Your Financial Records and IRS: "How
long should I keep records?")
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