Investing in Your 20s & 30s For Dummies - Eric Tyson

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to concern yourself with specifying which shares you’re selling.

      Determining the cost basis of your shares

      When you sell a portion of the shares of a security (such as a stock, bond, or mutual fund) that you own, specifying which shares you’re selling may benefit you taxwise. Here’s an example to show you why you may want to specify selling certain shares — especially those shares that cost you more to buy — so you can save on your taxes.

      Suppose you own 300 shares of a stock, and you want to sell 100 shares. You bought 100 of these shares a long, long time ago at $10 per share, 100 shares two years ago at $16 per share, and the last 100 shares one year ago at $14 per share. Today, the stock is at $20 per share. Although you didn’t get rich, you’re grateful that you haven’t lost your shirt the way some of your stock-picking pals have.

      The Internal Revenue Service allows you to choose which shares you want to sell. Electing to sell the 100 shares that you purchased at the highest price — those you bought for $16 per share two years ago — saves you in taxes now. To comply with the tax laws, you must identify the shares that you want the broker to sell by the original date of purchase and/or the cost when you sell the shares. The brokerage firm through which you sell the stock should include this information on the confirmation that you receive for the sale.

      The other method of accounting for which shares are sold is the method that the IRS forces you to use if you don’t specify before the sale which shares you want to sell — the first-in-first-out (FIFO) method. FIFO means that the first shares that you sell are simply the first shares that you bought. Not surprisingly, because most stocks appreciate over time, the FIFO method usually leads to your paying more tax sooner. The FIFO accounting procedure leads to the conclusion that the 100 shares you sell are the 100 that you bought long, long ago at $10 per share. Thus, you owe a larger amount of taxes than if you’d sold the higher-cost shares under the specification method.

Although you save taxes today if you specify selling the shares that you bought more recently at a higher price, when you finally sell the other shares, you’ll owe taxes on the larger profit. The longer you expect to hold these other shares, the greater the value you’ll likely derive from postponing, realizing the larger gains and paying more in taxes.

      When you sell shares in a mutual fund, the IRS has yet another accounting method, known as the average cost method, for figuring your taxable profit or loss. This method comes in handy if you bought shares in chunks over time or reinvested the fund payouts in purchasing more shares of the fund. As the name suggests, the average cost method allows you to take an average cost for all the mutual fund shares you bought over time.

      Selling large-profit investments

      No one likes to pay taxes, of course, but if an investment you own has appreciated in value, someday you’ll have to pay taxes on it when you sell. (There is an exception: You hold the investment until your death and will it to your heirs. The IRS wipes out the capital gains tax on appreciated assets at your death.)

      Capital gains tax applies when you sell an investment at a higher price than you paid for it. As I explain earlier in this chapter, your capital gains tax rate is different from the tax rate that you pay on ordinary income (such as from employment earnings or interest on bank savings accounts).

      Odds are that the longer you’ve held securities such as stocks, the greater the capital gains you’ll have, because stocks tend to appreciate over time. If all your assets have appreciated significantly, you may resist selling to avoid taxes. If you need money for a major purchase, however, sell what you need and pay the tax. Even if you have to pay state as well as federal taxes totaling some 35 percent of the profit, you’ll have lots left. (For “longer-term” profits from investments held more than one year, your federal and state capital gains taxes probably would total somewhat less.)

      

Before you sell, do some rough figuring to make sure you’ll have enough money left to accomplish what you want. If you seek to sell one investment and reinvest in another, you’ll owe tax on the profit unless you’re selling and rebuying real estate (see Chapter 12).

      

If you hold several assets, to diversify and meet your other financial goals, give preference to selling your largest holdings with the smallest capital gains. If you have some securities that have profits and some with losses, you can sell some of each to offset the profits with the losses.

      Handling losers in your portfolio

      Perhaps you have some losers in your portfolio. If you need to raise cash for some particular reason, you may consider selling select securities at a loss. You can use losses to offset gains as long as you hold both offsetting securities for more than one year (long term) or hold both for no more than one year (short term). The IRS makes this delineation because it taxes long-term gains and losses on a different rate schedule from short-term gains and losses.

      If you sell securities at a loss, you can claim up to $3,000 in net losses for the year on your federal income tax return. If you sell securities with net losses totaling more than $3,000 in a year, you must carry the losses over to future tax years.

      

Some tax advisors advocate doing year-end tax-loss selling with stocks, bonds, and mutual funds. The logic goes that if you hold a security at a loss, you should sell it, take the tax write-off, and then buy it (or something similar) back. When selling investments for tax-loss purposes, be careful of the so-called wash sale rules. The IRS doesn’t allow the deduction of a loss for a security sale if you buy that same security back within 30 days. As long as you wait 31 or more days, you won’t encounter any problems.

      

If you’re selling a mutual fund or exchange-traded fund, you can purchase a fund similar to the one you’re selling to easily sidestep this rule.

      Selling investments when you don’t know their original cost

      Sometimes, you may not know what an investment originally cost you, or you received some investments from another person, and you’re not sure what they paid for them.

      If you don’t have the original statement, start by calling the firm where the investment was purchased. Whether it’s a brokerage firm or mutual fund company, the company should be able to send you copies of old account statements, although you may have to pay a small fee for this service.

      Also, increasing numbers of investment firms, especially mutual fund companies, can tell you upon the sale of an investment what its original cost was. The cost calculated is usually the average cost for the shares you purchased.

      Preparing Your Investing Foundation

       Identify what should be included in your personal financial plan.

       Understand bank and credit union accounts, as well as what they are and aren’t good for.

       Make sense of money market funds and how to find the best one for your situation.

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