The Single Biggest Tax Break You Shouldn’t Forget

Find out how to cut down on those taxes below. Photo: Alan Cleaver, via Flickr.

Paying your fair share of taxes is important. It provides the money necessary to build the roads you drive on, pay for the schools you will (or did) send your kids to, and many other conveniences. At the same time, there’s no need to pay more than what you’re required to come April 18th.

According to an interview  between Kiplinger’s and former IRS commissioner Fred Goldberg, there’s one tax “break” that so many elderly Americans forget to take advantage of, Goldberg says it costs them, “millions in overpaid taxes.”

I put quotes around “break”, because this actually isn’t about a tax break at all; rather, it’s a common mistake that is easily made when people redeem their ETF or mutual fund shares for disbursement—whether in retirement, or to make a big life purchase. This mistake is limited to non-retirement accounts, and is all about the effect of dividend reinvestment.

A quick primer on investment taxes
Usually, the only time you’ll ever owe money on your investments (not including your Roth IRA) is when you cash them out. You could own shares of Company A for 10 years—with shares increasing 10-fold—and never pay a dime for gains that you see. That only happens when you sell your shares.

But for a large number of investors, there’s another ongoing tax situation that needs to be considered: dividends. Most of the time, working Americans make the smart choice to have dividends paid out by their mutual funds, ETFs, or individual stocks automatically reinvested—thus buying more securities. Even though that money is immediately spent, you will owe taxes for those dividends—with the amount varying depending on your overall income.

There’s nothing wrong with paying those taxes. In fact, it’s illegal to avoid them.

Where the big mistake is made
The scenario below isn’t necessarily realistic, as it involves a one-off transaction. But we’ll use it to demonstrate the principal behind this big mistake.

Let’s say that you bought $10,000 worth of shares of Vanguard’s Total Stock Market ETF (NYSEMKT: VTI) back in October 2002, and you’ve been reinvesting the dividends ever since. On December 1, 2015, that investment was worth $40,340 .

VTI Total Return Price data by YCharts

You decided to cash out the entire investment on December 1^st. Here’s what your tax situation would presumably look like from this investment, come tax time.

Here’s the thing: as intuitive as this all seems, you’ll be overpaying by a wide margin. Why? Because every time you received a dividend and reinvested it, you paid taxes on your dividends. With each reinvestment, you should also be increasing your cost basis. Failing to do so will cause your dividends to be taxed twice!

How big of a deal is this? It depends. But for our example investment in Vanguard’s Total Market ETF, take a look at the fund’s chart from 2002 to 2015, as shown on Google Finance.

Source: Google Finance

Each one of those blue Ds represents a dividend payment that—if not accounted for—will be taxed twice. After doing a little math, I found that the cost basis for this investment would have increased all the say to $12,735 because of dividend reinvestment between 2002 and 2015. That means the new tax situation look like this.

Therefore, in this one scenario, the taxpayer would be overpaying by $410. And like I said at the beginning, this isn’t a very realistic example. In real life, folks might be cashing out investments that paid bigger dividends, or that were purchased multiple times. That can make this dividend double-payment really add up.

First the good news, then the bad news, then the good news
Fortunately for those who started investing after 2012, the IRS now requires all firms to keep track of the cost basis for their customers—including dividend reinvestment. So this won’t really be a huge problem a few decades from now.

Unfortunately, that doesn’t help those who were invested in securities before 2012—likely the vast majority of investors reading this article and nearing retirement. If, however, you break out the elbow grease and contact your brokerage firm, you should be able to get the information you need to make sure you aren’t overpaying for those taxes.

Given enough time, you might be surprised at what a big difference it makes.