Sometimes it pays to stick your head under the hood to see what’s really going on.
It’s worth looking, for instance, at the “cost basis” your broker or mutual fund company reports for your investments, especially for mutual funds. A misunderstanding about this figure can give you a deeply distorted view of your investment returns.
Cost basis is the money you paid to acquire an asset like a stock, bond or mutual fund. To figure profits or losses, you subtract your cost basis from your sales proceeds.
It sounds simple, but then the plot thickens. Financial programs such as Quicken typically report gains and losses in a way that can be used to figure taxes. While that’s perfectly valid and very useful, it’s not the same as figuring your return, which you need to do to decide whether to keep the investment.
The confusion comes with the treatment of reinvested earnings, such as dividends, interest or capital gains distributions, each of which is taxed in its own way.
In mutual funds, bonds earn interest and stocks earn dividends, and the investor can have the earnings automatically used to buy more fund shares.
Capital gains distributions are your share of net profits the fund realized on stocks, bonds or other assets the fund manager sold during the year. Federal law requires that these gains be paid out to fund investors, and they usually come in “year-end distributions” received in November or December. Sometimes they are whoppers. Last December, for example, the Vanguard Precious Metals and Mining Fund (Stock Quote: VGPMX) made distributions equal to nearly 20 percent of the fund’s share price.
As with interest and dividends, most investors have distributions automatically reinvested in more fund shares.
But unless the fund is in a tax-favored account like a 401(k) or IRA, all three forms of payouts are taxed in the year they are received. They are reported on the 1099 form that comes in January.
Because these payments are taxed at this point, they are not taxed again when the investor sells the fund shares later. So the payments are added to the cost basis for figuring taxes.
Imagine, for example, that you paid $10 a share for XYZ mutual fund, and that over the years you’ve received $6 per share in various types of payouts that were taxed at the time. Suppose you later sold the shares for $20 each.
For tax purposes, your cost basis is $16 a share, figured by adding the $6 in reinvested payments to the initial purchase price of $10. After the sale you would owe tax on the $4 capital gain, figured by subtracting the $16 cost basis from the $20 sales proceeds. At a 15% capital gains tax rate, you’d owe 60 cents a share.
But in figuring your investment return, the interest, dividends and capital gains payouts are not included in the original cost. You originally spent $10 for shares that were sold for $20, so your profit is $10. That’s a lot better than $4.
These days, most fund companies and brokerages provide detailed reports that show your actual investment return over time, not just your taxable gains after selling shares. But it pays to keep your own records, to be sure of using the right cost basis figure. If you forget about all those reinvested earnings, you could end up paying more tax that you should.
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