For investors, buying and selling shares of mutual funds isn’t just as simple as clicking a few buttons on your computer screen. Aside from the required research needed to make an informed decision about which fund to buy, there are a few more important points that investors overlook during the process. One of the biggest is choosing their cost-basis accounting.
New rules enacted just a few years ago have helped change the game for investors with regards to potential taxable liabilities. Add in the fact that taxes seem to be rising across the board, and understanding how to limit your potential liability is paramount. And yet, most investors truly have no idea how the simple selection can help or hinder their future.
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What Exactly Is “Cost Basis Accounting”?
The only things certain in life are death and taxes. Cost basis reporting helps the IRS with the latter of the two. Every time you sell shares of an investment—stock, bond, exchange traded fund (ETF), mutual fund or whatever—in a taxable account you will pay capital-gains tax on the difference between what you paid for the asset and what you sold it for.
Cost basis is essentially the “what you paid” part of the transaction plus or minus any adjustments due to dividends, interest, returns of capital, etc. The buy and sell transactions are reported on IRS Form 8949, which you receive come tax time and will need to include in order to pay your taxes. Investments held in tax-deferred accounts—like 401(k)s and traditional IRAs—or those in tax-free accounts—such as Roths—are not required to report cost basis when selling.
Prior to 2012, mutual fund and brokerage companies were not required to keep track of cost basis information for investors. However, new legislation enacted requires them to do so under several different scenarios as chosen by the individual investor. This is great news for investors as it eliminates the headache of keeping paperwork for years, and allows them to shift their taxable liabilities depending on which of the cost basis methods they choose.
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Generally, investors will be asked to choose a cost basis option when they first open up a mutual fund account. However, investors can change their decision multiple times—usually during the selling process—to suit their individual tax needs. So you’re not really locked into a method for forever.
Cost Basis Methods
There are basically three categories of cost basis reporting that investors will encounter: average basis, FIFO, and specific lot/specialized basis. Each has its own pros and cons as well as unique tax issues.
Average Basis: This is the default option for many mutual funds. In average basis, all of your shares in a mutual fund have the same cost basis. The fund company will add up the total cost of all the shares you own and divide it by the total number of shares you own. The benefit to using average basis is that it’s simple to use and requires little-to-no record keeping. You won’t have to choose which shares to sell and your gains/losses are spread evenly across all shares you own
The drawback is that your gains and losses are spread evenly over all the shares you own. This may not be the best option if you’re concerned about minimizing taxable gains or maximizing tax losses. By averaging, you have no control over the gains or losses that are realized on the mutual fund sale, or the holding period between the purchase and sale of assets. Long-term and short-term capital gains are taxed differently.
FIFO: FIFO stands for “first in, first out.” In this method of cost basis accounting, the oldest shares purchased are the first ones sold. The benefit to using FIFO is that older shares should carry favorable long-term capital gains tax rates – currently at 15%. Short term rates can be as high as 39% for some investors.
However, the drawback to FIFO is that depending on how well or poor the investment has done, the gain or loss could be quite large. Like average basis, using FIFO may not be the best to maximize or minimize your taxable liability.
Specific Lot/Specialized Basis: Under this method of cost basis, investors have the choice of which shares to sell. While it requires you to be hands on, it is the best way to maximize tax efficiency. Based on the shares you select, you can manage the gains and losses that are realized on sales from your account. You can literally pick and choose how to best deal with your taxes.
Some mutual fund and brokerage companies will actually let you select lots during the sale process. However, most will use various standing orders to sell shares. These include: low cost, low cost long-/short-term, last in-first out, and minimize short-term gains.
The drawback to using Specific Lot/Specialized Basis methods is that you are forced to be very hands-on. While there are tools to help you decide what/when to sell, you’re still ultimately responsible for choosing. That can mean a bunch of extra paperwork and headaches come tax time. In fact, some mutual fund companies, such as Vanguard, don’t report cost basis for these methods to the IRS, meaning you’ll have to fill out your own cost basis information on Form 1040, Schedule D, come tax time.
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Unfortunately, there is no “best” method that suits all investors or their objectives. Each has its drawbacks and benefits when it comes tax time. For most longer termed investors, either average cost or FIFO tend to be the best, while specific lot reporting is better for those higher net worth investors that need to minimize their taxable liabilities down to the penny.
The Bottom Line
For investors, selling a mutual fund isn’t as easy as clicking “sell” in their brokerage accounts. The IRS wants its share as well. Luckily, new changes to legislation allow for investors to pick the cost basis reporting they wish to use to limit their potential taxes. By choosing between average cost, FIFO and specific lot designation, tax efficiency can be achieved.
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