Several years ago, we got a call from one of our clients at tax time who was not at all happy with their tax bill.
Instead of a small refund, as anticipated, they were looking at a $12,358 tax bill. Earlier in the year, following our recommendation, they had sold a mutual fund. We told them there wouldn't be much of a tax bill from the sale, but now it looked like the mutual fund sale was the culprit triggering that $12,358 tax bill. Ouch!
Here's what happened:
Instead of using the CPA we recommend to all our clients, they decided to do their own tax return using one of the popular software programs. When it came time to enter the mutual fund sale, they remembered what they paid for the fund and what the fund sold for; which is what they entered in the software program.
But they forgot to add into their tax cost all the dividends they had received over the years and had automatically reinvested back into more shares of the fund. Since they had already paid tax on those reinvested dividends, the dividends should have been added to their overall tax basis or tax cost.
Once they went back and did this, instead of a $12,358 tax bill, they ended up with a $579 refund.
Make sure you use the correct tax basis when you sell an investment. This is one of the most common mistakes we run across, which could cause you to overpay on your taxes.