A recent Morgan Stanley snafu highlighted the importance of understanding your cost basis when investing. During the tax years 2011 through 2016, Morgan Stanley inadvertently gave some of its 3.5 million wealth management clients the wrong tax information, according to Liz Hoffman in a recent Wall Street Journal article. The upshot? Morgan Stanley clients who sold their shares used inaccurate data to calculate the amount they owed to the IRS. And that, in turn, led them to either inaccurately pay capital gains taxes or incorrectly claim capital losses.

Ordinarily, when you inaccurately calculate your tax basis and then indicate a gain or loss on your taxes, you are liable for the mistake. In this case, since Morgan Stanley owned up to its misstep, the company is settling the inaccuracies with the IRS, on their clients’ behalf, with no additional cost to the account holders. Additionally, the firm is reimbursing clients who overpaid their taxes.

Morgan Stanley set aside $70 million to rectify their errors. The company claims that, in 90% of the cases, the over- and underpayments were less than $300 and more than half amounted to less than $20.

Why You Need to Know Your Cost Basis

The Morgan Stanley tax basis debacle highlights the importance of taking responsibility for tracking the basis of your stock and bond transactions. (See: Tax Planning Strategies for Individuals in 2017.) Ordinarily, you might buy a stock or bond and then file the confirmation statement or just leave the records on the brokerage accounts “confirmations” page. Over time, the stock might split and the asset will garner dividend payments or reinvestments into additional shares. These activities ultimately impact the asset’s basis.

When it comes time to sell, if you don’t keep meticulous records you will have a challenge on your hands. Don’t expect your accountant to bail you out of this tax record-keeping responsibility. Additionally, there’s another reason to keep track of and understand your tax basis. By knowing how it is calculated, you can manage your financial asset sales to minimize the amount of money you’ll owe the IRS. (Read: What You Need to Know About Capital Gains and Taxes.)

The Schwab Center for Financial Research demonstrates how targeting specific shares to sell (the specific share identification method) can dramatically influence the amount of tax owed. First in, first out (FIFO) is a common method of identifying shares to sell. Yet, by selecting specific shares with a higher cost basis before you sell, you can potentially save yourself thousands of tax dollars.

In the example below, when selling 100 shares, the FIFO method nets a capital gain of $8,980. That’s because you paid $10.10 per share for the initial purchase. But, if you sell shares of the same stock that you bought at a later date for $60.02 per share, you’ll reduce your capital gain to $3,988. Obviously, this is a dramatic example of a stock that experienced a sixfold increase. Yet, even with smaller gains, it’s wise to keep meticulous records so that when you sell, you’ll pay less tax to the IRS.

Alternate Methods to Calculate Capital Gains Taxes

Method Cost Proceeds Capital Gain
FIFO

$1,1010 

(100 shares x $10.10/share

$9,990 $8,980
Specific ID

$6,002

(100 shares x $60.02/share)

$9,990 $3,988

Data source: Schwab Center for Financial Research

The Bottom Line

The Morgan Stanley account holders are fortunate that, despite the firm’s reporting mistake, they won’t be liable for the capital gain or capital loss reporting error on their 1040 Schedule D. Nevertheless, the story is a reminder that it’s ultimately your responsibility, as an investor and a taxpayer, to keep track of the cost basis of your investments. Be sure to maintain the records of financial asset purchases, sales, stock splits, cash dividend payments and reinvestment amounts. Then, when it come times to sell, you’ll have the information needed to accurately calculate your capital gain or loss, in a way that is to your advantage. 

 

 

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