The Error-Proof Portfolio: Don’t Pay Tax Twice Properly ...

[Pages:2] The Error-Proof Portfolio: Don't Pay Tax Twice

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The Error-Proof Portfolio: Don't Pay Tax Twice Properly tracking reinvested dividends and capital gains can save you a bundle over time.

by Christine Benz

It's reflexive for many mutual fund investors: When they're filling out an application for a new account, they check the box indicating that they'd like their dividends and capital gains reinvested to buy more fund shares. For those in accumulation mode especially, it's often preferable to reinvest those stragglers rather than taking the cash in hand. That way you benefit as those additional purchases compound and grow.

Yet if you are reinvesting dividends and capital gains in funds you hold in your taxable account, you need to take steps to ensure that you're not paying more tax than necessary. That's because you're paying tax on those distributions in the year in which you receive them--the fund reports those distributions on the 1099 form that you receive and you have to transfer that information onto your tax forms. Those distributions, in turn, increase your cost basis in the fund, meaning that you wouldn't have to pay taxes on them again when you sell. (Your cost basis is the price you paid for an asset, adjusted for commissions, reinvested dividends and capital gains, and stock splits.) But if you haven't kept good records about what dividends and capital gains you've reinvested and already paid tax on, you could end up paying tax on those distributions again when you sell.

Double Taxation in Action Let's take a simplified example. Say you bought 1,000 shares of a fund for your taxable account at the end of 2009; you paid $18.25 per share for a total of $18,250. In 2010, with the share price still at $18.25, the fund made a dividend distribution of $0.54 per share, or $540 for your 1,000 shares. You'd owe tax on that distribution on your 2010 taxes, whether you reinvested the money or took the cash in hand. (You wouldn't owe any taxes if your owned the fund in a tax-sheltered account, however.

If you reinvested the money in the fund, it's as if you took money out of your pocket and did so. Thus, the reinvestment increases the number of shares you own, as well your cost basis in the fund. (Anytime you add money from any source, it increases your cost basis.) In this case, you'd now own 1,029.589 shares--your original 1,000 plus the nearly 30 more shares that you were able to buy with the $540 dividend distribution (your $540 dividend distribution divided by an $18.25 share price equals 29.589 shares). If you sold in 2010, with the fund's net asset value at $20, you'd owe taxes on your $1,801.78 profit in the fund ($20,591.78--your 1,029.589 shares at a share price of $20--minus $18,790, your cost basis).

If you hadn't been factoring in those reinvested dividends as part of your cost basis, however, you'd owe taxes on $2,341.78--the difference between your original purchase price ($18,250) and the value of your account when you sold ($20,591.78). You'd be giving the Internal Revenue Service tax on $540 more than you were actually required to do. At today's low tax rates of 15% on dividends, that's only a difference of $81, but imagine how that amount could be magnified over many years and many different accounts. If the currently low dividend tax treatment expires at the end of 2012, as it's set to do, that would further ratchet up the costs of not properly tracking the effect that reinvested dividends and capital gains have on your tax bill.

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What You Can Do? For those not comfortable with the idea of laboring over spreadsheets, tracking cost basis properly--factoring in reinvested dividends and capital gains as well as commissions and stock splits--might seem like a huge headache. One piece of good news is that beginning this year, financial firms will be required to track and report clients' cost basis directly to the IRS. The new cost-basis tracking and reporting requirements go into effect for individual stocks in 2011; for mutual funds in 2012; and for everything else (including fixed-income securities and options) in 2013. As part of the new rule, which is a component of the Emergency Economic Stabilization Act of 2008, fund companies and brokerage firms are required to alert clients to their default method for calculating cost basis; clients will also be allowed to specify which cost-basis method they'd like their firms to use. (This article delves into the new cost-basis requirements and provides an overview of the various methods you can choose.)

That doesn't mean that you never have to worry about tracking cost basis again, however. The rule doesn't apply to securities purchased before the new rules went into effect. For stocks purchased prior to 2011; mutual funds purchased prior to 2012; and other securities purchased before 2013, the onus is still on investors to track and report their cost basis.

In an ideal world, you'd maintain a separate spreadsheet for each stock or fund, in which you document your purchase as well any reinvested dividends or capital gains, stock splits, or commissions. You'd then update your spreadsheet on an ongoing basis.

But what if you haven't been doing this? Is it too late to get an accurate read on your cost basis? Not necessarily. Start by taking a look at each tax return you've filed since you had the investment. Reinvested dividends and capital gains will be on Schedules B and D, respectively. However, many brokerage firms just lump together all your dividends and capital gains across accounts for tax purposes. If that's the case, you'll just see something like "Schwab" listed, not each individual security. And for cost-basis purposes, you need to break it out by individual security. Contact each brokerage firm and request year-end statements for as long as you've had the investment. The firms should show both purchase amounts and reinvested amounts. Increasingly, firms are also providing this information on their websites for their clients.

About the Author Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

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