Average Cost Basis Method: Definition, Calculation, and Alternatives

The value of mutual fund holdings held in taxable accounts is calculated using the average cost basis approach, which yields the profit or loss for tax reporting purposes. The cost basis of a security or mutual fund represents its original value.

The profits or losses for tax reporting are then ascertained by comparing the average cost with the selling price of the fund shares. The Internal Revenue Service (IRS) offers investors a variety of options for determining the cost of their mutual fund holdings, including the average cost basis.

Comprehending the Average Cost Basis Approach

Investors typically utilize the average cost basis technique when filing taxes on mutual funds. The brokerage company where the assets are kept receives reports using the cost basis approach. The entire amount invested in a mutual fund position, divided by the total number of shares owned, yields the average cost. For instance, the average cost basis of an investor with $10,000 in investments and 500 shares would be $20 ($10,000 / 500).

Cost Basis Method Types

There are alternative approaches, even though the average cost basis technique is what many brokerage companies use by default when it comes to mutual funds.

FIFO

When computing profits and losses, you have to sell the shares you got first when using the first in, first out (FIFO) approach. As an illustration, suppose an investor had 50 shares and bought 20 in January and 30 in April. The investor would have to utilize the 20 shares sold in January and the remaining ten from the second lot bought in April if the investor sold 30 shares. The original purchase prices in each period would influence the tax gain or loss since the purchases in January and April would have been made at different prices.

Additionally, an investment is deemed long-term if the investor has owned it for longer than a year. When comparing long-term investments to short-term investments—securities or money bought in less than a year—the IRS levies a smaller capital gains tax. Therefore, if the investor had sold holdings older than a year, the FIFO technique would result in fewer taxes being paid.

LIFO

Using the last in, first out (LIFO) strategy, an investor may sell their most recent shares first, followed by their earlier holdings. The LIFO technique is most effective for investors who wish to hang onto their original shares, which may be worth less than the market’s willingness to pay.

Costly and Inexpensive Techniques

Investors can sell their shares at their highest original purchase price using the high-cost strategy. Stated differently, the shares that were most costly to purchase were sold first. A high-cost strategy aims to provide investors with the least amount of capital gains tax due. For instance, an investor may have made a sizable profit on an investment but still needs money and doesn’t want to realize that profit.

A higher cost indicates that the profit margin on the sale will be the smallest when the original price is less than the market price. If investors wish to deduct other gains or income from their taxes by taking a capital loss, they may also employ the high-cost technique.

On the other hand, investors can sell the cheapest shares first using the low-cost approach. Put differently, the shares you bought at the lowest price are sold first. If an investor wants to realize a financial gain from an investment, they may use the low-cost approach.

Selecting a Cost-Basis Approach

After selecting a particular mutual fund, a cost-based technique must be followed. Investors will get the relevant yearly tax paperwork from brokerage companies about sales of mutual funds through their option of the cost-based approach.

Suppose investors are unsure which cost-based technique may reduce their tax liability for sizeable mutual fund holdings in taxable accounts. In that case, they should speak with a financial planner or tax expert. The average cost basis technique might not always be the best course of action from a tax perspective. Please be aware that if the investor is thinking about selling any of the assets and the holdings are in a taxable account, then the cost basis becomes significant.

Particular Method of Identification

The investor can select which shares to sell to maximize the tax treatment using a particular identification technique called specific share identification. Suppose, for illustration purposes, an investor buys 20 shares in January and 20 in February. The investor can sell five shares from the January lot and five from the February lot if they subsequently decide to sell ten shares.

An Illustration of Cost-Basis Comparisons:

Comparisons of cost bases can be pretty significant. Assume that an investor purchased the following funds in a taxable account in order:

$1,000 worth of shares at $30 is $30,000.
$10,000 total for 1,000 shares at $10 each.
One thousand five hundred shares at $8 per share, or $12,000.
$52,000 is the total amount invested; to find the average cost basis, divide $52,000 by the number of shares, or 3,500. Each share costs $14.86 on average.

The investor subsequently sells 1,000 fund shares for $25 apiece. The average cost basis technique would result in a $10,140 capital gain for the investor. Using an average cost basis, the gain or loss would be as follows:

(10,140) x 1,000 shares ($25 – $14.86).
The following outcomes may occur based on the cost-basis technique selected for tax purposes:

($25 – $30) x 1,000 shares = – $5,000 is the first in, first out.
$17,000 ($25 – $8) x 1,000 = Last in, First out
High cost: $5,000 ($25–$30) × 1,000 shares
Low cost: $17,000 ($25 minus $8) x 1,000

The investor would be better off using the high-cost approach or the FIFO method to determine the cost basis before selling the shares, purely from a tax perspective. There would be no tax on the loss if these strategies were used. On the $10,140 in profits, the investor must pay capital gains tax using the average cost basis approach.

Naturally, there’s no assurance that $25 will be the selling price for the remaining shares when they are sold, even if the investor sells the 1,000 shares following the FIFO technique. A decline in the stock price would wipe away most of the capital gains and result in losing the chance to earn a capital gain. Hence, investors have to decide whether to try to lower their taxes and run the risk of losing any unrealized profits on their remaining investment or to take the gain now and pay the capital gains taxes.

Conclusion

• Mutual fund positions can be valued using the average cost basis approach, which yields the profit or loss that needs to be reported on taxes.
• The original value of a security or mutual fund that an investor holds is represented by its cost basis.
• The entire amount invested in a mutual fund position, divided by the total number of shares owned, yields the average cost.