Many Americans so dread dealing with taxes that they ignore the topic unless prodded by an accountant. But, as tax levies on investors continue to rise, it’s all the more important for you to know the rules. Being a well-educated investor could save you thousands of tax dollars, says Rande Spiegelman, vice president of financial planning at the Schwab Center for Financial Research.
What should you be thinking about? It’s not just capital gains and losses. Savvy investors know how to manage the so-called “cost basis” and holding periods of their investments to help reduce gains that are subject to tax—or even to claim a tax loss when selling an otherwise profitable holding.
What’s cost basis?
Simply put, your cost basis is what you paid for an investment, including brokerage fees, “loads” and any other trading cost. This matters because your capital gain (or loss) will be the difference between the cost basis and the price at which you sell your securities. This cost is pretty easy to calculate—if you don’t reinvest dividends or dollar-cost average.
But if you buy over time—even automatically through a dividend reinvestment plan—each block of shares purchased is likely to have a different cost and holding period. Thus, you can pick and choose among the high- or low-cost and long- or short-term shares when you sell, and make the sale work to your best tax advantage. Alternatively, you can go with the default method (more on that in a moment), which requires zero effort or calculation on your part—but could cost you more in taxes.
Federal tax rules require brokerage firms to report your cost basis to the IRS when you sell an investment only if that investment was purchased after a one of the following dates:
Whether your cost basis gets reported to the IRS or not, you are the one who’s responsible for reporting the correct amount. And the accounting method you choose to identify the shares you sell can make a big difference in the amount of tax you end up paying. To understand why, you have to know a little about how the IRS looks at cost basis accounting.
First in, first out
The cost basis of your shares doesn’t matter a whole lot until you sell. But when you do, the IRS gives you two ways to calculate the cost basis with individual stocks and four ways to figure it with mutual funds.
The default method—the accounting method the IRS will assume for both stock and mutual fund sales in the absence of any instructions to the contrary—is called FIFO, or “first in, first out.” That means that if you sold 100 shares of a 1,000-share holding, the IRS will assume that the shares you sold were the first, or oldest, ones you bought. Those, of course, are likely to have the lowest cost and the highest tax obligation, assuming a rising market.
The other option with individual shares is called “specific identification.” Specific identification is the method likely to give you the most flexibility and potentially the best tax result.
Let’s say you bought 500 shares of XYZ Corp. 10 years ago for $10 a share, or $5,000, and you paid a $50 brokerage commission for a total cost of $5,050. Then you bought a second group of 500 shares several years later, paying $60 a share, or $30,000, plus a commission of $10, for a total of $30,010.
Now, let’s say this stock has continued to appreciate in value and each share is now worth $100. You want to liquidate 100 shares (assume a $10 commission on sale). You could owe taxes on $8,980 in gains—or on just $3,988 in gains, depending on which method you use, as you can see in the table below.
How do you “identify” the specific shares you want to sell? If you’re placing the order by phone, you can tell your broker which shares you’re selling (for example, “the shares I bought on July 5, 2012, for $11 each”).
If you’re online, the approach will vary by brokerage. At Schwab, you’ll see your cost basis method identified on the order entry screen; if you opt for the Specified Lots method, you’ll be able to select which lots you want to sell.
Your brokerage will confirm the sale of those specific shares, which allows you to report the higher cost and the lower capital gain on your tax return.
Options for mutual fund investments
Investors in mutual funds have two additional options: “average cost, single category” and “average cost, double category.” The “average cost, double category” method allows you to calculate an average cost for long-term and short-term gains in separate buckets. But this method is rarely used because it’s extremely complex from an accounting standpoint.
The simpler “average cost, single category” method allows you to figure the cost of the entire holding, divide by the number of shares owned, and come to an average cost before making your first sale. You then subtract this average cost from the sales proceeds to determine your gain or loss. This method provides the simplest way to handle mutual fund sales when you’re reinvesting dividends and/or regularly adding to your holdings.
There’s one major downside to using this method: If you choose it for your first sale, you must continue to use that method for every subsequent sale until you completely liquidate the holding. Additionally, opting for specific identification might save you money.
Let’s say, for example, that you buy mutual fund shares each month through an automatic investment plan. One month the shares might be up; the next month they might be down. You pay little mind and just invest the same amount each month, a process called “dollar-cost averaging.”
To keep it simple, assume your lowest-cost shares were the first purchased at $10; your highest-cost shares were purchased at $100; and your average cost was $50. We won’t factor in commissions here. You have 1,000 shares.
Now the market value of these fund shares is $60 and you want to sell 100 shares. Let’s compare three ways your sale could play out. You could use the first in, first out tactic and sell your lowest-cost fund shares. You could go with average cost, single category, which would simply use the average per-share price. Or you could use specific ID and sell your highest-cost shares.
As you can see in the table below, depending on the accounting method you choose, you can book a modest capital gain—or it might be more advantageous to take a loss.
Choosing a method
The best accounting method to choose is going to depend on you. If you have modest holdings and don’t want to keep close track of when you bought and sold shares, using the average cost method with fund sales and the FIFO method with the sale of individual shares is probably fine.
But if you’re a tax-sensitive investor, specific identification can save you lots of tax money—especially if you use other tax-wise strategies, such as giving appreciated shares (rather than cash) to charity. (You get credit for a charitable donation for the full market value of donated long-term shares, subject to certain income limitations, but because the charity is tax exempt, no one pays the capital gains taxes.)
What you can do now
- Find out which cost basis method is your current default. If you’ve never investigated, chances are you’re defaulted into FIFO for stocks and average cost, single category for mutual funds.
- Adjust your defaults if they’re not what you’d like them to be, and pay attention to what method you’re using the next time you sell.
- If you’re a Schwab client, you have access to a cost basis method called the Tax Lot Optimizer™. This method automatically looks for losses (short term, then long term) before realizing gains (long term, then short term).
- Before entering into any significant transaction, consult your tax professional on what method will work best for you.