Cost basis methods

Introduction
If you sell shares of a mutual fund in a taxable account, you pay capital-gains tax on the difference between the cost basis (which is usually the purchase price) and the sale price. You must choose an accounting method for each fund you hold in order to determine the basis. IRS Publication 564 describes the four allowed methods for mutual funds. (You may not use averaging methods for individual stocks.)

The examples in this page show the different tax effects in the following sample situation:


 * Ten years ago, you bought 100 shares at $30.
 * Five years ago, you bought 100 shares at $40.
 * Six months ago, you bought 100 shares at $50.
 * Two months ago, you bought 100 shares at $60.
 * Today, you want to sell 100 shares at $60.

FIFO (first in, first out)
In this method, the first shares purchased are assumed to be the shares sold. In the example above, you sell the shares bought ten years ago; since you bought them for $3,000, your capital gain is $3,000.

This is the default accounting method; the IRS assumes that you used it unless you have records to support another method.

This method is the simplest, but it usually leads to the largest tax bills if you use it for stock funds, because shares tend to rise in value and the oldest shares will usually be the ones bought for the lowest price.

Average cost, single category
In this method, all of your shares in a fund have the same basis, which is the average cost (or other basis) of all shares at the time they were purchased. Shares are still sold in the order purchased. In the example above, you paid $18,000 for 400 shares, so your average cost is $45; when you sell 100 shares at $60, your capital gain is $1,500. It is a long-term gain since you sold the shares you bought ten years ago.

Vanguard provides the records for using this method; if you use another method, you need to ignore Vanguard's reported gains on the confirmations you receive.

Average cost, double category
In this method, you have separate sub-accounts of short-term and long-term shares, and you may sell shares from either sub-account, but you need to specify which account you are using and receive confirmation of the choice, or it will be assumed that all sales are from long-term shares. Within each sub-account, your basis is the average cost of all shares in that category and you sell the oldest shares in the category. In the example above, you have 200 short-term shares with an average cost of $55, and 200 long-term shares with an average cost of $35. When you sell 100 shares at $60, you could choose to sell short-term shares for a capital gain of $500 (taxed at the higher short-term rate) or long-term shares for a capital gain of $2,500.

Given the record-keeping burden, it is rarely worth using this method; if you are going to keep the necessary records, you might as well use specific identification of shares for the greater tax benefit.

Specific identification
In this method, you may choose which shares to sell. You must be able to adequately identify the shares sold; the IRS says that you can do this if you specify the shares sold to the agent (the broker or mutual fund company) at the time you make the sale, and receive written confirmation from the agent selling the shares. In the example above, you could choose to sell the 100 shares bought two months ago for a zero capital gain.

If you hold stock certificates (very rare for mutual funds, and no longer common even for individual stocks), then you specify which shares to sell by which certificate you give to the broker for the sale.

This method requires the most record-keeping (particularly if your brokerage doesn't make it easy, and Vanguard doesn't), but it allows you to minimize your tax bills, and the tax savings can be very large. See Specific Identification of Shares for more information about the advantages, and details of how to use this method with Vanguard.

Changing methods
Once you have used the single-category or double-category averaging method for a mutual fund, you must continue to use it for all sales of the same fund, unless you get IRS permission to change. However, you can change methods from FIFO or from specific identification; if you made your first sale as FIFO, you may specifically identify another sale as long as you do not sell the shares already sold. You may also use different methods for different funds in the same account, such as using FIFO for a bond fund (for which the method doesn't matter much) and specific identification for a stock fund.

Cautions
There are some complications to the computation of basis and some restrictions on taking of losses. See the links below for more information, and do not treat this wiki page as tax advice.

Links

 * IRS Publication 564
 * Fairmark mutual fund tax guide