# Average Cost Basis Method

## What Is the Average Cost Basis Method?

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

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. The average cost basis is one of numerous methods that the Internal Revenue Service (IRS) allows investors to use to show up at the cost of their mutual fund holdings.

## Figuring out the Average Cost Basis Method

The average cost basis method is regularly utilized by investors for mutual fund tax reporting. A cost basis method is reported with the brokerage firm where the assets are held. The average cost is calculated by partitioning the total amount in dollars invested in a mutual fund position by the number of shares owned. For instance, an investor that has \$10,000 in an investment and possesses 500 shares would have an average cost basis of \$20 (\$10,000/500).

## Types of Cost Basis Methods

Albeit numerous brokerage firms default to the average cost basis method for mutual funds, there are different methods accessible.

### FIFO

The first in, first out (FIFO) method means that when shares are sold, you must sell the first ones that you acquired first while computing gains and losses. For instance, suppose an investor owned 50 shares and purchased 20 in January while purchasing 30 shares in April. In the event that the investor sold 30 shares, the 20 in January must be utilized, and the leftover ten shares sold would come from the subsequent parcel purchased in April. Since both the January and April purchases would have been executed at various prices, the tax gain or loss would be affected by the initial purchase prices in every period.

Likewise, on the off chance that an investor has had an investment for over one year, it would be considered a long-term investment. The IRS applies a lower capital gains tax to long-term investments versus short-term investments, which are securities or funds acquired in under one year. Subsequently, the FIFO method would bring about lower taxes paid on the off chance that the investor had sold positions that were over a year old.

### LIFO

The last in first out (LIFO) method is the point at which an investor can sell the latest shares acquired first followed by the recently acquired shares. The LIFO method works best if an investor has any desire to hold onto the initial shares purchased, which may be at a lower price relative to the current market price.

### High-Cost and Low-Cost Methods

The high-cost method allows investors to sell the shares that have the highest initial purchase price. All in all, the shares that were the most costly to buy get sold first. A high-cost method is intended to furnish investors with the lowest capital gains tax owed. For instance, an investor could have a large gain from an investment, however doesn't have any desire to understand that gain yet, yet needs money.

Having a higher cost means the difference between the initial price and the market price, when sold, will bring about the littlest gain. Investors could likewise utilize the high-cost method to assume a capital loss, from a tax standpoint, to offset different gains or income.

On the other hand, the low-cost method allows investors to sell the lowest-priced shares first. All in all, the cheapest shares you purchased get sold first. The low-cost method may be picked if an investor has any desire to understand a capital gain on an investment.

### Picking a Cost-Basis Method

When a cost basis method has been decided for a specific mutual fund, it must stay in effect. Brokerage firms will furnish investors with fitting annual tax documentation on mutual fund sales in view of their cost basis method races.

Investors ought to counsel a tax advisor or financial planner assuming they are unsure about the cost basis method that will limit their tax bill for substantial mutual fund holdings in taxable accounts. The average cost basis method may not generally be the optimal method according to a taxation point of view. If it's not too much trouble, note that the cost basis possibly becomes important in the event that the holdings are in a taxable account, and the investor is thinking about a partial sale of the holdings.

### Specific Identification Method

The specific identification method (otherwise called specific share identification) allows the investor to pick what shares are sold to enhance the tax treatment. For instance, suppose an investor purchases 20 shares in January and 20 shares in February. Assuming that the investor later sells 10 shares, they can decide to sell 5 shares from the January part and 5 shares from the February parcel.

## Illustration of Cost Basis Comparisons

Cost basis correlations can be an important consideration. Suppose that an investor made the following continuous 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 separating \$52,000 by 3,500 shares. The average cost is \$14.86 per share.

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

• (\$25 - \$14.86) x 1,000 shares = \$10,140.

Results can fluctuate contingent upon the cost-basis method picked for tax purposes:

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

From rigorously a tax standpoint, the investor would be better off choosing the FIFO method or the high-cost method to work out the cost basis before selling the shares. These methods would bring about no tax on the loss. Notwithstanding, with the average cost basis method, the investor must pay a capital gains tax on the \$10,140 in earnings.

Of course, assuming the investor sold the 1,000 shares utilizing the FIFO method, there's no guarantee that while the leftover shares are sold that \$25 will be the selling price. The stock price could diminish, clearing out a large portion of the capital gains and an opportunity to understand a capital gain would have been lost. Thus, investors must gauge the decision with regards to whether to take the gain today and pay the capital gains taxes or try to reduce their taxes and risk losing any unrealized gains on their leftover investment.

## Highlights

• The average cost is calculated by separating the total amount in dollars invested in a mutual fund position by the number of shares owned.
• Cost basis addresses the initial value of a security or mutual fund that an investor claims.
• The average cost basis method is an approach to computing the value of mutual fund positions to determine the profit or loss for tax reporting.