Average Cost Basis Method: Simplifying Mutual Fund Tax Reporting

What Is the Average Cost Basis Method?

The average cost basis method is a system of calculating the value of mutual fund positions held in a taxable account to determine profit or loss for tax reporting. Cost basis represents the initial value of a security or mutual fund that an investor owns.

The average cost is then compared with the price at which the fund shares are sold to calculate gains or losses. The average cost basis is one of many methods that the Internal Revenue Service (IRS) allows for determining the cost of mutual fund holdings.

How the Average Cost Basis Method Works

The average cost basis method is commonly used by investors for mutual fund tax reporting. You must report your chosen cost basis method to the brokerage firm holding your assets.

The average cost is calculated by dividing the total amount in dollars invested in a mutual fund position by the number of shares owned. An investor who has $10,000 in an investment and owns 500 shares would have an average cost basis of $20 ($10,000 ÷ 500).

Various Methods for Calculating Cost Basis

Many brokerage firms default to the average cost basis method for mutual funds but other methods are available.

The First In, First Out (FIFO) Cost Basis Method

You must first sell the first shares that you acquired when you’re calculating gains and losses using the first in, first out (FIFO) method.

Let’s say an investor owned 50 shares and purchased 20 in January then purchased 30 shares in April. The 20 in January must be used if the investor sold 30 shares. The remaining 10 shares sold would come from the second lot purchased in April. Both the January and April purchases would have been executed at different prices so the tax gain or loss would be impacted by the initial purchase prices in each period.

If an investor holds shares for over a year, it’s considered a long-term investment. The IRS taxes long-term investments at a lower rate than short-term ones, which are held for a year or less. The FIFO method would therefore result in less taxes paid if the investor sold positions that were more than a year old.

The Last In, First Out (LIFO) Cost Basis Method

The last in, first out (LIFO) method is used when an investor can sell the most recent shares acquired first followed by the previously acquired shares. The LIFO method works best if an investor wants to hold onto the initial shares purchased. They might be at a lower price relative to the current market price.

Gains would be short-term in this case, however, if the last-in shares are held for one year or less. Gains wouldn’t be taxed at the more favorable long-term capital gains rates but at the investor’s marginal regular income tax rate.

Long-term capital gains are taxed at rates of 0%, 15%, or 20%. Regular income tax rates vary from 10% to 37% based on taxable income. More income pushes the rate higher.

Comparing High-Cost and Low-Cost Basis Strategies

The high-cost method lets investors sell shares with the highest initial purchase price first. The shares that were the most expensive to buy get sold first.

A high-cost method is designed to provide investors with the least capital gains tax owed. An investor might have a large gain from an investment. They don’t yet want to realize that gain but they need the money.

Having a higher cost means that the difference between the initial price and the market price when sold will result in the smallest gain. Investors might also use the high-cost method if they want to take a capital loss for tax purposes to offset other gains or income.

The low-cost method allows investors to sell the lowest-priced shares first. This method might be chosen if an investor wants to realize a capital gain on an investment.

Selecting the Right Cost Basis Method for Your Needs

A cost basis method must remain in effect after it’s been chosen for a specific mutual fund. Brokerage firms will provide investors with appropriate annual tax documentation on mutual fund sales based on their cost basis method elections.

If unsure about minimizing taxes, investors should consult a tax advisor or financial planner. The average cost basis method may not always be the optimal method from a taxation point of view.

Utilizing the Specific Identification Cost Basis Method

The specific identification method, also known as specific share identification, allows the investor to choose which shares are sold to optimize the tax treatment.

Let’s say an investor purchases 20 shares in January and 20 shares in February. They can choose to sell five shares from the January lot and five shares from the February lot if they later want to sell 10 shares.

Illustrative Examples of Cost Basis Method Comparisons

Suppose an investor made the following consecutive fund purchases in a taxable account:

• 1,000 shares at $30 for a total of $30,000
• 1,000 shares at $10 for a total of $10,000
• 1,500 shares at $8 for a total of $12,000

The total amount invested equals $52,000 and the average cost basis is calculated by dividing $52,000 by 3,500 shares. The average cost is $14.86 per share.

The investor then sells 1,000 shares of the fund at $25 per share. The investor would have a capital gain of $10,140 using the average cost basis method. The gain or loss using average cost basis would be as follows:

• ($25 – $14.86) × 1,000 shares = $10,140

Results can vary depending on the cost basis method chosen for tax purposes:

• First in, first out: ($25 – $30) × 1,000 shares = -$5,000
• Last in, first out: ($25 – $8) × 1,000 = $17,000
• High-cost: ($25 – $30) × 1,000 shares = -$5,000
• Low-cost: ($25 – $8) × 1,000 = $17,000

The investor would be better off from a tax standpoint by selecting the FIFO method or the high-cost method to calculate the cost basis before selling the shares. These methods would result in no tax on the loss. The investor must pay a capital gains tax on the $10,140 in earnings with the average cost basis method, however.

Of course, there’s no guarantee that $25 will be the selling price when the remaining shares are sold if the investor sold the 1,000 shares using the FIFO method. The stock price could decrease, wiping out most of the capital gains and an opportunity to realize a capital gain. Investors must weigh whether to take the gain today and pay the capital gains taxes or to try to reduce their taxes and risk losing any unrealized gains on their remaining investments.

The Bottom Line

The average cost basis method calculates gains or losses on mutual fund positions in taxable accounts for tax reporting, using the original purchase value, known as the cost basis, as the starting point.

While widely used, other methods, like FIFO, LIFO, high-cost, low-cost, and specific identification, can lead to different tax outcomes. Accurate reporting with brokerage firms is essential, and consulting a financial or tax advisor can help determine the most tax-efficient approach for individual circumstances.