Content provided by Matt Santini, CLS Portfolio Manager
Today, I thought I would share what I think is one of the most common individual tax errors. Before I start, let me remind everyone that neither I, nor CLS are worthy tax advisors. It is the investor’s responsibility to seek tax advice from a professional.
Federal law mandates that virtually all dividends and capital gains from mutual funds must be passed on to shareholders. The investment companies will send out 1099 forms presenting their distributions for the year. Unless the funds are held in a tax deferred account (401K, IRA, etc), the investor is now immediately responsible for that tax liability. Many shareholders choose to reinvest gains (compounding) back into the same investment product.
It is that common reinvestment that tends to trigger the most common personal tax error: paying taxes twice on the same gains. Many investors are guilty of paying taxes for the year they incur the distributions, and then years later when they sell shares of the same fund (some shares that were inevitably bought with already taxed proceeds). Since the IRS is not in the business of calculating, but rather charging, it is imperative the investor keep records.
Those reinvested dividends have now become part of the cost basis. Here is an example:
Initial investment: $5000
Total 1099 amounts: $1500
Proceeds from eventual sale: $8000
A lot of people tend to neglect the taxes they already paid from the 1099’s over the years and report a capital gain of $3000 on final the sale. In fact, they should be reporting a capital gain of only $1500.
Since the IRS is not in the business of calculating, but rather charging, it is imperative you keep diligent records.