Some of you may have already received a notice from your mutual fund companies or your brokerage firms asking what method you would like used to determine the cost basis of your holdings. Perhaps you’re not sure
what cost basis is,
what are the different methods to calculate cost basis,
which method is best for you, or how you will make a choice,
and why you’re even being asked?
We all invest to make profits, right? Either we do well because we sell our mutual fund or stock shares for more money than we paid, or we receive interest and dividends.
Whether your investment is a share in a mutual fund or a share of stock, your cost basis is your purchase price, plus reinvested dividends.
For example, if you paid $50 for a share of Mega Gains Large Cap Fund and were lucky and smart enough to sell it for $300 per share, you would have a gain of $250 per share. In this case, your cost basis is $50 per share. Easy-peezy.
But what about the dividends you received? If Mega Gains Large Cap Fund has paid you dividends, which you reinvested, after paying tax on the gain, your basis stays the same, but you get to reduce your gain by the amount of dividends that you reinvested. What if you chose not to reinvest your dividends? Then they won’t affect your cost basis.
Now, let’s say you were so happy with your success that every couple of weeks you purchased another ten shares of Mega Gains Large Cap Fund. You do this for a couple of months while the price of the fund goes up and down. Now, when you sell shares, and you set out to calculate your gain, you have a problem. You bought shares at many different prices. So, when your accountant asks for your cost basis information, so he or she can calculate your taxable gain, how are you ever going to figure it out?
That’s where the good news lies — because starting January 1, 2012, the Emergency Stabilization Act of 2008 requires your brokerage firm or mutual fund company to provide a default average price. They’ll do the calculations, so you don’t have to. [They’re also required to share the information with the IRS. Wonder what they’ll do with it? ]
But there is something you do have to do — that’s where your choice comes in. There are four different methods used to calculate cost basis, and it’s up to you to choose the one that your brokerage or your mutual fund will use. Here are the typical choices:
FIFO – First In First Out, the former example above
LIFO – Last In Last Out, the later example above
Highest Cost First Out, you always sell your most expensive share first
Lowest Cost First Out, you always sell your least expensive share first
Average cost, and more.
Lowest Cost First Out, you always sell your least expensive share first
Average cost, and more.
What you choose will depend upon whether or not you want to defer income, whether the investment price has been trending up or down, or the specific tax strategy that you have for this holding in your investment portfolio.
How permanent is the cost basis selection decision? It depends on your brokerage firm. It’s not very permanent except if you select the average costs basis method for your mutual funds. In that case, if you change the basis method, the change will only apply to future purchases after the change has been was executed.
What’s my recommendation? Get input from both your tax advisor and your investment advisor. Make a choice and return the form! After all, if the IRS is going to know all about your cost basis, you should too. Ideally you have an investment plan that incorporates the benefits of tax planning. If you don’t, now is the time to see an independent hourly financial planner to advise you on how to make your investments work harder before and after income taxes.