Dividend Expert's Year-End Tax Tips

12/02/2020 5:00 am EST


Charles Carlson

Editor, DRIP Investor

Yes, it is getting to be that time of year — and here are some year-end tax tips to consider for 2020, explains Chuck Carlson, dividend reinvestment expert and editor of DRIP Investor.

Remember to include reinvested dividends in your cost basis. When you sell an investment in a taxable account, you incur a potential tax liability if you sell the investment at a profit.

You determine the profit or loss based on your “cost basis,” which is the amount of money you invested in the investment. Determining the cost basis on an investment can be challenging if you keep shoddy records. However, you will need to compute a cost basis for tax purposes on any security that is sold in a taxable account.

The easiest way to compute the cost basis (and this method works best if you sell the entire investment) is by adding up your total investments — 1) the amount of your initial investment; 2) the amount of any additional investments you made while owning the stock; and 3) the total amount of dividends that you reinvested.

For example, let’s say you bought a stock that cost you $5,000. And over five years, you invested an additional $5,000 in the stock. And let’s say you reinvested dividends each year that totaled $400 over the five years you owned the stock.

Your cost basis would be $5,000 plus $5,000 plus $400, or $10,400. You would deduct this amount from the sale proceeds to determine your gain or loss for tax purposes.

Forgetting to include reinvested dividends in the cost basis is a common mistake made by investors, especially those in dividend reinvestment plans.

Remember — by excluding reinvested dividends, you reduce your cost basis, thereby inflating your profits and taxes on those profits. If you maintain good records, the amount of reinvested dividends is available on the DRIP statements you receive from the transfer agent.

You are not required to take required minimum distributions from IRAs in 2020. Of course, if you need the money, you can take those distributions from your IRA. However, you are not required to take them this year if you previously were required to take RMDs.

If you do not need the money, it makes the most sense to defer taking distributions since you must pay taxes on any distributions from an IRA. It has not been determined if the waiver on IRA required minimum distributions will continue in 2021, but I would not assume that it will.

Consider tax harvesting to reduce your tax bill. Tax harvesting is the practice of selling stocks with losses to offset realized gains. Remember that you only incur potential tax liabilities when you realize capital gains by selling the investment. You do not pay taxes on unrealized gains, which are gains on investments you still hold.

Tax laws permit you to offset realized gains with realized losses. Let’s say you have sold stock and are now sitting with $10,000 in realized long-term gains. (Long-term gains are profi s incurred when selling an investment you held for at least 12 months.)

For most individuals, the long-term capital-gains tax rate is 15%. Now, if you have unrealized losses in your portfolio, you can realize those losses by selling the stock. Those losses can offset the gains, thus reducing your total net realized gains and, therefore, your tax bite.

Continuing the example, you sell stock that has losses of $15,000. In this instance, you can offset your entire $10,000 gain and still have $5,000 in losses leftover.

If you have more realized losses than gains, current tax laws allow you to apply $3,000 in losses to this year’s income and carry forward the additional losses to future years. So, in our example, you would take $3,000 in losses in 2020 to reduce your income and carry forward $2,000 in losses to 2021.

Keep in mind you can carry losses forward indefinitely. If you tax harvest, do not run afoul of “wash sale” rules. A wash sale occurs when an investor sells a security at a loss, then within 30 days before or after the sell buys the identical (or substantially the same) security.

For example, if you sell a stock to book a loss for tax-harvesting, you cannot have bought that security 30 days before the sale, and you cannot buy the security 30 days after the sale. Therein lies one risk of tax harvesting — selling a stock that moves sharply higher within that 30-day window.

Still, if you know you are going to have a pretty stiff tax bill, and you own stocks with unrealized losses that you have soured on, you should sell the stocks, book the loss, offset some of the gains, and reduce your tax liability.

Remember to adjust your cost basis for spin-offs. If you own a large number of stocks, chances are good that you’ve received spin-offs from some of your holdings. For example, I’ve owned Bristol-Myers Squibb (BMY) for many years. In 2001, Bristol-Myers spun off Zimmer (ZBH) to shareholders.

If I sold Zimmer this year, I would need to compute my cost basis for tax purposes. In order to do that, I would need to know the “cost allocation” percentage for Zimmer, which means I would need to devote a portion of my cost basis in Bristol-Myers Squibb prior to the spin-off to Zimmer.

The upshot is that every time you receive shares in a spin-off, you will need to adjust the cost basis on the “original” shares as well as determine a cost basis for the spin-off shares. The best source for information on spin-offs and how to handle them for cost-basis purposes is the company’s “Investor Relations” or “Shareholder Services” sections of the corporate Web sites.

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