Planning with the New Cost Basis Reporting Rules

In November of 2010 I wrote an article that discussed the new cost basis reporting rules that began to take effect for stocks in 2011 and will expand to include mutual funds beginning in 2012.  The article explained that these rules will require you to declare a standing order on which shares of stock you want to sell before you sell them.  This is a VERY important part of this new rule and I think it needs further clarification.

Right now, if you sell shares of stock or mutual funds, you need to calculate the gain or loss by subtracting the price you paid for the shares (your cost basis) from the proceeds you received when you sold the shares.  When you sell all the shares you own of a particular holding this is fairly easy.  It gets a little trickier when you sell only a portion of the shares and the shares were bought at different times.  In this case you would need to figure out which shares you are selling so that you can calculate their basis.

There are many different methods of assigning cost basis to shares that are sold, such as FIFO, LIFO, highest cost, lowest cost, and average cost.  Typically people would wait until they were filing that year's tax returns before deciding on a method so that they could use the most tax efficient cost basis.  This was never really an "allowed" way of determining cost basis because you were supposed to assign basis to the shares at the time of sale.  Of course there was never a way for the IRS to tell when the basis determination had been made... until now.

Now that the IRS has mandated reporting of cost basis by custodians, you will have to determine a cost basis method by the settlement date of the trade.  If you do not choose a method, the custodian will choose their default method for you and you will be locked in to that method.  And you will be locked in to that method for all the remaining shares of that holding in that account!

This can have a major impact on both your tax planning AND your investment planning.  Often times people will sell shares of an investment that have an unrealized loss in order to take that loss to offset any gains and reduce their taxable income.  Now imagine you sold some high cost shares of an investment in order to realize a loss.  If you don't make the election with the custodian to use the "highest cost shares", they will use the default method, which in the case of mutual funds will be “average cost”.  If there are some shares of the same investment in that account with a lower cost basis, the average cost method could end up giving you a much lower basis and completely undermine your tax planning strategy.

There are many intricacies to these new rules but suffice it to say that this is something that all of you should keep in mind when selling any investments going forward.  We recommend you contact us or your investment custodian to be sure you are clear on the rules before completing a sale.  If you have an investment manager executing trades for you, be sure they are taking into account the new rules as well.  

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Just Another Short Term Patch

Last week we told you about the super committee’s failure to reach an agreement on a deficit reduction deal.  We also discussed the ongoing negotiations to reach a compromise on the future of the payroll tax cut that was set to expire at the end of the year.  Even though there seemed to be unanimous agreement that an extension of the cut for another year was the best course of action, Democrats and Republicans were still unable to reach an agreement on such an extension.  Instead they settled on a 2 month extension of the cut, in effect simply punting the issue into next year where we will go through this process all over again. 

I won’t go into the details of the back and forth between the two parties or the drama that unfolded this past week.  The end result is that nothing will change for taxpayers for the next two months.  The payroll tax that was set to rise back to 6.2% from 4.2% will instead stay at the lower rate. 

I’m sure we will be back in February with another update on this issue from our dysfunctional government.

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Legislative Update

In my last update in November I discussed the so called super committee and their looming deadline to reach an agreement on a plan to reduce the deficit.  As you are all aware by now, they did not meet that deadline and no agreements were reached.  The “super” committee turned out to be not so super after all!

As expected this led to more volatility in the markets with the S&P 500 dropping about 5% from the day I wrote that article to a low point on November 25.  From there it began climbing back up with good reports from the retail sector on Black Friday.  It then surged even higher on news that the Federal Reserve would work with other central banks to support the global economy.  As of today the S&P 500 is back up about 7% from that low point.

So what have we learned from all this?  Well it appears that our government leaders are incapable of agreeing on much of anything these days so don’t expect any major changes to the tax system before next year’s presidential election.  However there is one piece of legislation that seems to be gaining steam and might be resolved before the holiday break.

You might remember that last year Congress acted to reduce the payroll tax for 2011 to spur economic growth.  This reduction is set to expire at the end of the year, which would mean an increase in taxes of $1,000 for the average family.  There seems to be agreement among both Republicans and Democrats that the payroll tax cut should be extended through next year but of course they can’t seem to agree on how to pay for it.  Democrats want to pay for the cut with a surtax on those making more than $1 million a year while Republicans plan to use spending cuts to pay for it. 

I will not attempt to predict what will happen as these two political parties fight each other over the next week before they pack up and head home for the holidays.  Instead I will keep an eye on their progress; if and when they are able to pass legislation, I will post an update here.  As always, stay tuned!

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Super Committee Update

With a November 23 deadline looming, we though it would be a good time to update you on the status of the super committee and their discussions to come up with a plan to reduce the deficit.  Back in August I wrote an article about the committee and what they were trying to accomplish.  Here are answers to some questions you might have right now:

What is the November 23 deadline?  If the committee can’t reach agreement by November 23 on a package that would cut the deficit by at least $1.2 trillion, automatic cuts of $1.2 trillion would kick in starting January 2013.  These cuts would be across the board to both defense and non-defense and would have a dramatic impact on our country. 

Where does the committee stand right now?  As with all political dealings, it really depends on who you talk to.  For every report that progress is being made, there seems to be another report that the talks have stalled.  Some progress has been made between the democrats and republicans but there is still a wide gap. 

What will happen to taxes?  Again it’s impossible to tell what is going to happen as a result of these discussions but it’s clear that taxes will play an important role in coming up with a solution.  The Republicans have proposed lowering the top tax rate while eliminating many popular deductions and making steep cuts to entitlement programs.  The Democrats would like to see increased tax rates for the wealthy and more balance between the tax increases and the spending cuts.  It is widely believed that if an agreement is reached, the committee could leave the difficult tax decisions to the House Ways and Means and the Senate Finance Committees.  They would simply set targets and policy parameters for a tax rewrite next year.  So even if an agreement is reached, we may still be left in the dark on the future of tax laws.

What about the $5 million estate and gift tax exemption?  There have been some rumors that there could be an early reduction of the $5 million estate, gift and generation-skipping transfer tax exemption.  It is currently set at $5 million through December 31, 2012 but will revert to $1 million barring further congressional action.  The rumors say that the exemption could be reduced as early as November 23, 2011 or January 1, 2012.  If you have considered taking advantage of this increase in the exemption, NOW is the time to move forward on this planning.  If you are wondering what this means, read Lyle’s article from back in February on this opportunity.

What happens if no agreement is reached?  While we would like to think this is a long shot, it certainly has to be considered.  If no agreement is reached we would expect more market volatility similar to what we saw in August and possibly even another downgrade of the US debt. 

As always we will continue to monitor the progress of the super committee and will let you know when and if an agreement is reached.  Stay tuned!

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Estate Planning Awareness Week

Did you know National Estate Planning Awareness Week is October 17-23, 2011?  I’m guessing you probably didn’t and you probably don’t know why you should care.  According to the National Association of Estate Planners and Councils, more than 120 million Americans do not have up-to-date estate plans to protect their families in the event of sickness, accidents, or untimely death.  The importance of this cannot be overstated and now is the perfect time to reassess your own personal situation. 

You might be thinking “I have a will so I am fine”, but there is a lot more to estate planning than having a will!  And even though you have a will, is it current?  The tax laws have changed significantly in recent years and some of the provisions in your will might no longer make sense and work the way you originally planned.  Also if you’ve had any major life changes such as marriage or kids then your estate planning documents need to be updated.

Retirement planning is also a significant part of estate planning.  A Roper poll commissioned by the AICPA found that two-thirds of Americans over age 65 believe they lack the knowledge necessary to adequately plan for retirement.  It’s important to understand what your needs will be in retirement and to come up with a plan for reaching your retirement goals. 

Twenty-six percent of Americans age 65-74 have a chronic illness that has had a significant impact on their lives.  Does your plan protect you?    Lyle recently discussed long-term care insurance in this article.  This is one way to plan for aging and disability but of course there are other things you can do to protect yourselves and your families.

When was the last time you had a comprehensive review of all your property, casualty and liability coverage?  As your life changes and your income and asset base grow through the years, you need to adjust your coverage to be sure that you are properly protecting your assets. 

Have you considered any estate planning strategies to take advantage of the current low interest rates to transfer wealth to future generations?  Loans to family members, installment sales, and certain types of trusts like grantor retained annuity trusts and charitable lead trusts all take advantage of the current low rates.

Estate planning can take many forms but it is critical for everyone to address.  So next week if you hear someone in the news mention Estate Planning Awareness Week, use it as an opportunity to think about your own situation and discuss it with your family.  Then let us know how we can help update and improve your plans.

You might also want to check out a webinar on Tuesday, Oct 18 at 2:30pm brought to you by the AICPA on this topic.  It’s called “Protecting you and Your Loved Ones: Practical and Vital Estate Planning Information for Consumers in Plain English” and you can access it here.  The webinar is free to attend.

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