As yearend approaches, many investments make payouts to shareholders through capital gain distributions, dividends, income, or other means. You’ll receive them as cash or reinvested shares. But interpreting the reports to determine how your investments actually performed can be confusing. Here’s how to decipher them.
Cost Basis Reporting
Most custodians will show cost basis reporting on their monthly statements and on their websites. This seems like a good place to review the performance of your investment, right? Not necessarily. Cost basis reports are designed to show the tax impact of any investment if you were to sell it. These reports are not designed to show you the total performance of your investment.
Since cost basis reports are created to show the tax impact of selling your investment, they account for any payments made to you such as dividends, interest, or capital gains. You must pay taxes on income payments from an investment in the year you receive them. To avoid double taxation these payments are offset on the cost basis report. Otherwise, you would pay taxes on the income the year you received it, and then again, as capital gains, when you sell the investment. Here are a few examples
Example #1: Income Paid to You as Cash
You bought investment ABC for $10,000. Today it’s valued at $11,000. This year the investment paid you $1,500 as income. This $1,500 is taxable income for this year. Since the investment sent you $1,500, it is only worth $9,500 ($11,000 minus the $1,500 it sent you as income). The cost basis will show a loss of $500 ($10,000 minus $9,500.)
It may appear the investment was a poor choice since the cost basis report shows you lost $500. What it doesn’t show is the $1,500 of income you received by holding the investment. The investment gave you $1,500 in income and lost $500 in principal for a total gain of $1,000 overall. In addition, if you sold the investment today you could take the $500 capital loss to help reduce your taxes. The investment performed well, but a quick look at the cost basis report, would only show that ABC investment was down $500.
Example #2: Reinvested Income
As in Example #1, you bought ABC investment for $10,000 and it’s now worth $11,000. This year the investment pays you $1,500 as income but reinvests it back into ABC. As an investor, you still owe taxes on the $1,500 of income even though you received no cash. Since you received more shares of ABC, your cost basis report now shows a cost basis of $11,500 ($10,000 of the original investment plus $1,500 of income that was reinvested).
The value of ABC initially drops to $9,500 ($11,000 minus $1,500 in income). However, since you reinvested the $1,500 of income you now own $11,000 worth of ABC. The cost basis report would show that you invested $11,500 in ABC and it’s worth $11,000 today, for a loss of $500. But you only invested $10,000 in ABC. The additional $1,500 was given to you by the investment. Again, you made $1,000 but the cost basis report will show a loss of $500.
What to Do?
Cost basis reporting can be very helpful to show where you stand regarding any potential future tax impact. However, it’s a poor standard for judging performance - especially for investments that have paid you income. To get true performance you need to know three things:
- What you paid for the investment,
- Total income paid to you by the investment, and
- What the investment is worth today.
With those three pieces you can get the overall performance of the investment. Cost basis on a custodial statement omits the total income paid to you by the investment and will not provide an accurate view of performance. If all you have is the cost basis, be sure to look for any income that the investment has paid to evaluate its overall performance.
Prior to implementing any investment strategy referenced in this article, either directly or indirectly, please discuss with your investment advisor to determine its applicability. Any corresponding discussion with a Bedel Financial Consulting, Inc. associate pertaining to this article does not serve as personalized investment advice and should not be considered as such.
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