Minimize Taxes Through Tax-Lot Management

Remembering that your employee, Uncle Sam, shares your “investment business’s” gains and losses, gives you a powerful incentive to keep adequate records for proving to him the source and amount of any income he claims is his.  In the past this required a lot of pencil pushing, but with the help of today’s computing power it has become a much simpler process.  Most accounting programs include the ability for you to keep a record of your activities.  At a minimum, you should be able to keep lot-by-lot prices of any purchases made, the quantity of shares or bonds, the date of purchase, and any commissions or other costs paid in conjunction with your purchases.  Special attention should be made in recording dividends that are reinvested and any accrued interest paid when purchasing a bond or other fixed income holding.   This gives you the ability to identify the specific gains and losses of any securities you have sold.

Lacking these records could substantially increase the amount of taxes you will pay.  This is because Uncle Sam tells you, that absent these records, you are required to record every sale using a first-in first-out accounting method.  Consider this; you have been reinvesting dividends on a blue chip common stock, buying shares quarterly for years.  You recently needed a little cash so you sold a few shares.  Without proper records, you would report the sale and record a gain on the first shares you bought years ago at a price well below today’s quote.  You may think that’s OK, after all, it’s a long term capital gain at the lowest tax rate.  But what if the amount you sold was less than the amount of dividends reinvested in the last couple of years? You’ve already paid tax on the dividends once, and yet the value of the shares you purchased upon reinvestment is worth less, and in many cases, a lot less than the amount of those dividends.  With proper records, you could sell those shares that are currently at a loss, deduct that loss from other income and still have the cash you need.  With a little record keeping you can go from paying taxes to receiving a tax benefit in just one easy step!

For those of you with mutual funds, besides first-in first-out you can use an average cost basis.  But why would you want to if tax-lot accounting puts you in control?  The rules encourage you to minimize your tax expense and maximize your earnings.  Keep some records so you can use the gains or losses created in the most tax efficient manner. 

Beginning next year, the IRS will require your custodian to provide additional information on form 1099-B.  Form 1099-B shares your sales proceeds with the tax man.  Beginning January 1, 2011, this form will also include an adjusted cost basis for securities sold and whether the gain or loss is short-term or long-term.  Without your input, you may be subject to the adjusted cost basis your custodian determines is the easiest and least expensive for them.  Easy is not always best.  You want to keep control.  When the time comes later this year, make sure you ask your broker or custodian what steps you can take to ensure that your records are maintained in your best interest.

Properly managing your sales with tax-lot accounting can make a substantial difference in the amount of taxes you pay.   Remember, the amount you keep after your taxes are paid is the true measure of performance.