Cost basis is an important part of investing — particularly when it comes to figuring out how much tax you might owe. Luckily, you don’t need to be a financial genius to understand what cost basis means and why it is important.
Essentially, it’s the price you paid for an asset or investment that serves as a “basis” from which you can calculate your capital gains. It is an important number when it comes to understanding how much you’ve made off an investment — which is important in order to understand how much you owe in taxes when you sell that asset.
Below, we break down what cost basis means, how to calculate it and why it matters in relation to common assets.
WHAT IS COST BASIS?
Cost basis is the total amount that you paid into an asset, like a stock, your home or even a permanent life insurance policy. It is usually calculated starting with the purchase price or, when it comes to permanent life insurance, the premiums you pay on your policy.
Basis also generally includes fees or commissions required to make an investment. For example, if you are purchasing stocks, you would calculate the cost basis by adding up the share price and any commissions or fees you had to pay to facilitate the purchase. This gets more complicated if you’re reinvesting dividends on a stock you purchased rather than taking them out as a capital gain. The reinvested dividends add to the cost basis of your stock holdings over time.
If you are purchasing a home, you can add things like attorney fees, owners title insurance, transfer taxes, real estate fees, and other closing costs to your cost basis. You might also be able to add the cost of certain home improvements to the cost basis of your property if they are permanent renovations that add value.
Cost basis is also sometimes referred to as “tax basis” because it’s often used to calculate taxes you will owe. When you sell your investment or asset you will need to determine your cost basis and subtract your basis from the amount you receive on the sale. The difference between the amount you receive and your cost basis determines the amount you owe in taxes.
HOW DO YOU CALCULATE YOUR COST BASIS?
An important part of calculating your cost basis is keeping good records. This can be easier for some assets and investments than others. For example, your investment brokerage account will typically keep track of the cost of your investments as well as the fees and other expenses related to your purchase or sale of investments.
However, calculating cost basis can be more complicated if you’re doing so for a home that you have lived in for a while and renovated over the years. Keeping good records or adding up your cost basis every year would make it easier to keep track.
The cost basis of your life insurance policy is relatively easy to calculate and often your insurer will calculate it for you. It’s typically the amount you paid in premiums for your policy.
WHY COST BASIS MATTERS WITH LIFE INSURANCE
With permanent life insurance, in addition to the death benefit, the policy will accumulate cash value that you can access throughout your lifetime.1 While there are several ways to access your cash value, including taking a loan against the policy, some people choose to surrender a portion or all of their policy .
When surrendering a policy, you can generally take your cash value tax-free up to the cost basis. Anything above that amount is taxed as ordinary income. Because of this, some people who no longer need their full death benefit choose to surrender a portion of their policy — taking out the amount of cost basis tax-free. Then, the rest of the policy stays intact, providing a legacy for loved ones.
WHY COST BASIS MATTERS ON INVESTMENTS AND ASSETS
Being able to calculate the cost basis of your investments and assets means that you will be better prepared to understand the tax implications of selling your investments – whether it’s a mutual fund you own or a family cottage you share with your siblings.
Unexpected and unplanned-for tax bills can have unpleasant financial consequences. Miscalculating cost basis could result in paying more than you need to in taxes. Knowing how to properly calculate cost basis could minimize your tax burden.
NEED HELP CALCULATING YOUR COST BASIS?
If you’re unsure how to calculate the cost basis of your investments or assets and want support, consider reaching out to a tax advisor. A tax advisor can help you understand how to calculate your capital gains using the cost basis of your investments or life insurance cash value so that you can come up with a tax strategy that works best for you and your financial goals.
1 Utilizing the cash value through policy loans, surrenders, or cash withdrawals will reduce the death benefit; and may necessitate greater outlay than anticipated and/or result in an unexpected taxable event. Assumes a non-Modified Endowment Contract (MEC).
This publication is not intended as legal or tax advice. Financial Representatives do not render tax advice. Consult with a tax professional for tax advice that is specific to your situation.