Define Average Cost Basis Method

Average Cost Basis Method

What Is the Method of Average Cost Basis?

The average cost basis approach determines the profit or loss for tax reporting by determining the value of mutual fund holdings maintained in a taxable account. The original value of a securities or mutual fund that an investor holds is referred to as the cost basis.

To establish the profits or losses for tax reporting, the average cost is compared to the price at when the fund shares were sold. The average cost basis is one of many techniques allowed by the Internal Revenue Service (IRS) for determining the cost of mutual fund assets.

The Average Cost Basis Method: An Overview

For mutual fund tax filing, investors frequently utilize the average cost basis technique. The brokerage business where the assets are kept reports the cost basis approach. The average cost of a mutual fund position is derived by dividing the total amount invested in dollars by the number of shares owned. An investor who has $10,000 in an investment and owns 500 shares, for example, has a cost basis of $20 ($10,000 / 500).

TAKEAWAYS IMPORTANT

• The average cost basis approach determines the profit or loss for tax reporting by assessing the value of mutual fund positions.

• The original value of a securities or mutual fund that an investor holds is referred to as the cost basis.

• The average cost of a mutual fund position is derived by dividing the total amount invested in dollars by the number of shares owned.

Cost Basis Methods: What Are They and How Do They Work?

Although many brokerage companies use the average cost basis technique when dealing with mutual funds, there are alternative options.

FIFO

When computing profits and losses, the first in, first out (FIFO) technique states that when selling shares, you must sell the first ones you bought first. Let's imagine an investor has 50 shares and purchases 20 in January and 30 in April. If the investor sells 30 shares, the first 20 must be used, and the remaining 10 must be acquired from the second lot in April. Because the purchases in January and April would have been made at different prices, the tax gain or loss in each quarter would be influenced by the initial purchase costs.

Also, an investment that has been held for more than a year is termed a long-term investment. Long-term investments pay a lower capital gains tax than short-term investments, which are securities or funds purchased in less than a year. As a consequence, if an investor sold holdings that were more than a year old, the FIFO technique would result in lesser taxes being paid.

LIFO

When an investor uses the last in first out (LIFO) approach, he or she can sell the most recently bought shares first, followed by previously acquired shares. The LIFO approach is excellent for investors who wish to keep the first shares they bought, which may be at a lower price than the current market price.

Methods with High and Low Costs

Investors can sell the shares with the highest original purchase price using the high-cost strategy. To put it another way, the shares that were the most expensive to purchase are the first to be sold. A high-cost strategy is intended to save investors money on capital gains taxes. For example, an investor may make a huge profit on an investment but may not want to take it yet since he or she needs funds.

With a larger cost, the gap between the starting price and the market price will result in the smallest gain when the item is sold. Investors may also utilise the high-cost option if they want to use a capital loss to offset other gains or income for tax purposes.

The low-cost technique, on the other hand, permits investors to sell the cheapest shares first. To put it another way, the cheapest shares you bought are sold first. If an investor wishes to achieve a capital gain on an investment, the low-cost technique may be employed.

Selecting a Cost-Basis Approach

Once a cost basis technique for a mutual fund has been determined, it must be followed. Investors will get relevant yearly tax paperwork on mutual fund transactions depending on their cost basis method elections from brokerage providers.

If investors are unsure about the cost basis method that will minimize their tax bill for substantial mutual fund holdings in taxable accounts, they should consult a tax advisor or financial planner. From a taxes standpoint, the average cost basis technique may not always be the best option. Please keep in mind that the cost basis is only relevant if the assets are held in a taxable account and the investor is considering a partial sale.

Method of Specific Identification

The particular identification technique (also known as specific share identification) allows an investor to pick and select which shares to sell in order to maximise tax benefits. Let's imagine an investor buys 20 shares in January and another 20 shares in February. If the investor decides to sell 10 shares later, they can sell 5 from the January lot and 5 from the February lot.

Cost Basis Comparisons as an Example

• Cost basis comparisons are an essential factor to consider. Assume that in a taxable account, an investor purchased the following funds in a row:

• For a total of $30,000, you may buy 1,000 shares at $30 each.

• For a total of $10,000, you may buy 1,000 shares at $10 each.

For a total of $12,000, you may buy 1,500 shares at $8 each.The entire investment is $52,000, and the average cost basis is derived by dividing the total investment by 3,500 shares. The average price per share is $14.86.

Let's say the investor sells 1,000 shares of the fund for $25 each. Using the average cost basis technique, the investor would have a capital gain of $10,140. The following is the gain or loss using average cost basis:

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

• The cost-basis technique used for tax reasons might affect the outcome:

• ($25-$30) x 1,000 shares = - $5,000 first in, first out.

• Last in, first out ($25 - $8) multiplied by 1,000 is $17,000.

• ($25-$30) x 1,000 shares = $5,000 high cost

• Low cost: $17,000 ($25 - $8) x 1,000

The investor would be better served using the FIFO approach or the high-cost method to compute the cost basis before selling the shares from a strictly tax perspective. There would be no tax on the loss if these strategies were used. The average cost basis technique, on the other hand, requires the investor to pay capital gains tax on the $10,140 in profits.

Of fact, if the investor used the FIFO approach to sell 1,000 shares, there's no assurance that $25 will be the selling price when the remaining shares are sold. The stock price might fall, wiping off most of the capital gains and denying you the opportunity to earn a profit. As a result, investors must decide whether to take the profit now and pay capital gains taxes, or to delay taking the profit and risk losing any unrealized gains on their remaining investment.