The average cost basis method is integral for calculating the value of mutual fund positions in a taxable account, necessary for determining profit or loss during tax reporting. Cost basis represents the initial value of a security or mutual fund that an investor owns.
What Is the Average Cost Basis Method?
The average cost is then compared with the price at which the fund shares were sold to determine the gains or losses for tax reporting. This is one of the many methods allowed to arrive at the cost of mutual fund holdings.
Understanding the Average Cost Basis Method
The average cost basis method is commonly used for mutual fund tax reporting. It requires a cost basis method to be reported with the brokerage firm holding the assets. The average cost is calculated by dividing the total invested amount in a mutual fund by the number of shares owned. For instance, an investor with $10,000 in an investment owning 500 shares has an average cost basis of $20 ($10,000 / 500).
Key Takeaways:
- The average cost basis method helps determine the profit or loss for tax reporting.
- Represents the initial value of a security or mutual fund that an investor owns.
- Calculated by dividing the total invested amount by the number of shares owned.
Types of Cost Basis Methods
FIFO: First In, First Out
The FIFO method means selling the longest-held shares first. For example, an investor who owned 50 shares and purchased 20 in January and 30 in April must use the January acquisition for the initial 20 shares and the rest from April when calculating gains or losses. If an investment is held for over a year, it qualifies as a long-term investment with lower capital gains tax compared to short-term investments.
LIFO: Last In, First Out
With the LIFO method, the most recently acquired shares are sold first. It benefits investors who wish to keep initial, lower-priced shares.
High-Cost and Low-Cost Methods
The high-cost method prioritizes selling the most expensive shares, potentially minimizing gains and taxes owed. The low-cost method targets the cheapest shares first, suitable for realizing capital gains.
Choosing a Cost Basis Method
Once selected, the cost basis method for a specific mutual fund must be adhered to. Brokerages offer annual tax documentation based on the cost basis method chosen. Consult a tax advisor if uncertain about minimizing your tax bill.
Specific Identification Method
This method allows the investor to pick specific shares to sell, optimizing the tax treatment. For instance, choosing to sell half of the shares from January and half from February.
Example of Cost Basis Comparisons
Assuming an investor made the following purchases in a taxable account:
- 1,000 shares at $30 ($30,000)
- 1,000 shares at $10 ($10,000)
- 1,500 shares at $8 ($12,000)
The total amount invested is $52,000, with an average cost basis of $14.86 per share. Selling 1,000 shares at $25, the capital gain using the average cost basis method would be:
- ($25 - $14.86) x 1,000 shares = $10,140
Comparing cost basis methods for tax purposes:
- FIFO: ($25 - $30) x 1,000 shares = $-5,000
- LIFO: ($25 - $8) x 1,000 shares = $17,000
- High cost: Same as FIFO = $-5,000
- Low cost: Same as LIFO = $17,000
For the lowest taxes, FIFO or high-cost methods are preferable as they show a loss, while the average cost basis requires tax on $10,140 in earnings. However, the remaining shares’ future value uncertainty calls for careful strategy planning.
Related Terms: Capital Gains, Shares, Taxable Accounts, IRS.
