Tuesday, January 10, 2012

How to Minimize Your Taxes: 1040 Good Buddy!

If I made enough money writing my books and this blog to afford a lawyer, she'd likely advise me to issue a disclaimer of some sort.

So here we go!

WARNING: This is not meant to be specific tax advice. Please consult a tax professional (CPA if you're lazy or TurboTax if you're not!) for your specific situation. Certain side affects that have been observed when reading this blog are similar to Viagra and include head ache, blurred vision,  and delayed back pain (likely due to sitting on a fatter wallet). 

With 2011 now in the books, it's time to start thinking about income taxes (and how to minimize them!).  Here's an article about a few tax changes for 2011

One of the most important changes relates to capital gain reporting on the sale of investments. In the past, your broker or mutual fund company only reported sales amounts to the IRS.  It was up to you to determine and report your cost basis and thus your capital gain (or loss).  Starting with 2011 brokers and mutual funds will report the cost basis to the Internal Revenue Service (IRS) on new Form 8949.  This should make our lives easier when filling out Schedule D (Capital Gains and Losses) for our Form 1040.  I don't know how many times I had to dig through years of old files to figure out my cost basis of a stock or fund I sold.  The IRS even had the foresight to add a place where you can adjust the broker reported cost basis just in case your broker made a mistake. Click here for IRS instructions for reporting Capital Gains and Losses and click here for IRS instructions for Form 1040.

One vitally important item NOT mentioned in the article above was:
You have a choice on how to account for your cost basis.  For example, if you purchased a stock or fund at various points in time at differing prices, you can choose among three cost calculation methods:

  1. Average Cost Method
  2. First-in, First-out Method
  3. Specific Identification Method  <--winner, winner! - pick me, pick me! ;)

The Average Cost Method and First-In, First-Out Method are simpler for your broker to calculate, but the Specific Identification Method gives you a better opportunity to minimize your taxes.

An Example

Perhaps you bought 100 shares of a stock or mutual fund and paid $80 per share. Then, 6 months later you bought 100 more shares at $90 per share.  Then suppose you needed to sell 100 shares 2 years later and received $88 per share when you sold those 100 shares.

(Keep in mind, this really does not matter within your tax sheltered accounts like your IRA, Roth IRA, or 401(k), but does matter in your regular taxable accounts. Hopefully, you have money in all four accounts!)

Average Cost Method

With the Average Cost method you would report an average cost of $85 via the following calculation:

$80 x 100 shares = $8,000
$90 x 100 shares = $9,000

This gives you a total of 200 shares that cost $17,000 ($8,000 + $9,000)

So, your Average Cost would be $17,000 / 200 shares = $85 per share

Therefore, your Capital Gain on your sale at $88 per share would be 88-85 = $3 per share for a total taxable Capital Gain of $300.

First-In, First-Out Method

With the First-In, First-Out method you would report a cost basis of just $80 per share.

Capital Gain = $8,800 - $8,000 = $800

Specific Identification Method

With the Specific Identification Method you could specify that you sold only the 100 shares that cost you $90 per share.  Thus, you could report a Capital Loss as follows:

Cost Basis = $90 x 100 shares = $9,000
Sales Proceeds = $88 x 100 shares = $8,800

Capital Loss = $8,800 - $9,000 = a loss of -$200

Summary Conclusion

I would much rather report a loss of -$200 to the IRS and reduce my tax bill as opposed to reporting a taxable gain of $300 or $800. I suspect everyone would want the same.

Due to this new IRS tax reporting change, here is the important thing you need to do right NOW. As soon as possible, contact your broker or mutual fund company and tell them which method you would prefer to use going forward.

If you don't tell them which you prefer, many brokers and mutual funds will default to a less tax efficient method since it is more convenient for them.  For example, TD Ameritrade's default is Average Cost Method for mutual funds and First-In, First-Out Method for stocks.  You really don't want either one of those if you want the flexibility to minimize your taxes.  

If you invest at Vanguard, you can click here to specify which method you prefer.

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