You’ve done the right thing – investing for the long haul with an eye toward retirement. So you might be tempted to disengage, letting the markets and compounding interest carry the ball toward your goal line. After all, I did use a recent column to recommend a passive approach to investing.
Still, there are important things to keep in mind. One of them is “cost basis.” This is, essentially, what you paid for an investment. It comes into play when you sell some or all of a holding, or when you die and leave portions to your heirs. And it can get tricky, particularly with investments you’ve held for a long time.
Perhaps you don’t recall what you paid for some of your investments, or you inherited some holdings from a parent or grandparent and have no idea what they were worth the day he or she died. Our information economy has its limits; by law, investment companies only have had to keep cost-basis records since 2011. You might be able to look back further on some sites, but you’re pretty much limited to the 21st century. Unless you or your late relative was a meticulous record keeper – and someone maintained those records – it’s hard to know the cost basis. The best I can suggest is that you reach out to a financial professional who might have access to additional tools and resources.
Perhaps you’ve kept an investment for a while and reinvested the dividends. The additional shares you purchased likely have different “cost bases” than the shares you originally bought. Theirs would be the value when the reinvestments occurred. When you look to divest, the shares you choose to sell can have tax implications.
Short-term investments – those held for a year or less – are taxed differently, but cost basis is essential to determining capital gains or losses. For example, if you sell a stock you owned for a year or less, your capital gains will be taxed at your ordinary income-tax rate. If you sell a stock that you owned for 366 days or more, you will be taxed at the long-term capital gains rate, which ranges from zero to 20 percent. If your ordinary income-tax rate is lower than 15 percent, you might not have to pay capital-gains tax on the sale.
The goal with any investment is to earn capital gains. With those gains come taxes once the investments are sold. Therefore, sometimes people hold onto investments to avoid the tax implications. If you never sell those investments, there is an upside for your heirs. When you pass away, the cost basis for your investments are “stepped up” to the date of your death. Your heirs will not be taxed on the capital gains you made during your lifetime.
Say you purchased an investment for $10 a share 30 years ago. Today, the price is $100 per share. If you sell today, you will be taxed on $90 per share – the additional value accrued over the three decades. Should you die today, the cost basis for your heirs would be $100 a share; they would be taxed only on gains going forward if they decided to sell the investment.
The bottom line here is that even if you have a solid financial plan with a passive approach, you shouldn’t simply put your investments on autopilot. Maintaining a basic knowledge of what you bought and when, will enable you to make informed decisions about when and what to sell – which can make a big difference in the amount of taxes you will pay.
Editor’s note: Mr. Carlat is a Glendale-based financial adviser.