Investors Need to Get Specific with Brokers to Avoid Big Tax Bills

Updated
Stock brokers
Stock brokers

Whenever tax laws change, it can have an impact on how you manage your investments. One recent new law, though, gets your broker or mutual fund company in on the act -- and they'll need you to make a decision that could make a huge difference in how much you pay in taxes.

The new law requires brokers and fund companies to start providing the IRS with information on how much you paid for shares that you sell. Also known as the "cost basis," this amount helps the IRS calculate how much in capital gains or losses you should report on your tax returns.

The IRS wants this information to help it track tax cheaters. Previously, the IRS relied on you to report the correct numbers. That made it easy for unscrupulous taxpayers to report incorrect amounts, and if the IRS didn't audit their tax returns, they often got away with it.

Getting the Wrong Answer?

The new law went into effect for stocks in 2011, and people are already reporting problems.

Some brokers are reporting incorrect information, and although you can offer corrected values yourself, discrepancies will likely increase your audit risk. For mutual funds, the law takes effect this year, so you can expect problems to multiply during next year's tax season.

The most important way to protect yourself is to specify that the brokerage use the best cost basis method. For simplicity, the typical methods of first-in-first-out or average cost for mutual fund shares may look attractive. But to minimize your taxes, the best choice is to track your cost basis yourself, and when it's time to sell your shares, specifically identify the shares to sell that will produce the lowest tax bill.

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The specific identification method can produce big savings. For long-term investors whose stocks have risen in value over time, first-in-first-out usually means selling your lowest-cost shares first -- producing the most gain. If you've bought shares in the same company regularly, that rarely makes sense, as there's almost always at least one period during which shares were expensive. Sell those shares, and you can reduce your taxable gain or even get a loss you can use on your taxes next year.

Having your broker or fund company do the dirty work with gains and losses may sound like a godsend. But their mistakes could cost you plenty, so keep your eyes open and make sure they get it right.

For more on taxes:

Motley Fool contributor Dan Caplinger trusts no broker. You can follow him on Twitter here.

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