Many people dislike thinking about taxes—so much that they ignore the topic until filing season is upon them. Unfortunately, waiting until the last minute to deal with tax matters can lead them to miss opportunities to potentially reduce their tax bill.
Investors who include tax planning as part of their investing strategy could potentially see significant tax benefits over the long run, says Hayden Adams, CPA, CFP® director of tax and financial planning at the Schwab Center for Financial Research.
You shouldn't just be thinking about 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 taxes. Knowing your cost basis can be a valuable tool.
What is cost basis?
Simply put, your cost basis is what you paid for an investment, including brokerage fees, "loads," and any other trading cost—and it can be adjusted for corporate actions such as mergers, stock splits and dividend payments. 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 easy to calculate—if you don't reinvest dividends or dollar-cost average when you invest.
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 automatic default method, which requires less effort on your part, but could cost you more in taxes.
It's also important to note that determining the cost basis for bonds can be a bit more complicated, based on whether you bought them at "par" (face value), paid a premium, or got a discount. Fortunately, bonds that are purchased from 2014 onward, are now required to have the brokerage firm provide each investor with tax documents that contain the cost basis for the asset.
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 one of the following dates:
- Equities (stocks, including real estate investment trusts, or REITs) acquired on or after January 1, 2011
- Mutual funds, ETFs, and dividend reinvestment plans acquired on or after January 1, 2012
- Other specified securities, including most fixed-income securities (generally bonds) and options acquired on or after January 1, 2014
Whether or not a brokerage reports your cost basis to the IRS, you're responsible for reporting the correct amount when you file your taxes. And the cost basis method you choose to identify the shares you sell can make a big difference in the amount 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 method
The "first in, first out" (FIFO) cost basis method is Schwab's default method for determining which assets were sold, for all investments other than mutual funds, if you don't provide instructions to the contrary.
If you purchased 1,000 shares over a number of years and you sold 100 of those shares, the FIFO method assumes that the shares you sold were the first ones purchased (the oldest shares). Generally, the shares you've held the longest are the ones you purchased at the lowest cost, which means the FIFO method could result in the largest gain recognized and the highest tax obligation.
Specific identification method
The other option with individual shares is called the "specific identification" method. The specific identification method takes a bit more effort, but it allows you to select the shares that are sold and gives you the most flexibility and potentially the lowest tax liability. Let's look at an example of how specific identification works.
Say you bought 500 shares of XYZ Corp. 10 years ago for $10 a share ($5,000 total), and you paid a $50 brokerage commission for a total cost of $5,050 ($10.10 a share). Several years later, you bought a second group of 500 shares for $60 a share ($30,000 total) and paid a commission of $10, for a total of $30,010 ($60.02 a share).
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 (assuming a $10 commission on the sale). Depending on which method you use, you could owe taxes on $8,980 in gains or on just $3,988 in gains. (See the table below for details.)
Calculate cost with care to pay less tax
By specifically identifying the shares you want to sell, in this hypothetical example, you would owe much less in capital gains tax.
(100 shares x $10.10/share)
(100 shares x $60.02/share)
How do you identify the specific shares you want to sell?
If you're placing the order by phone, tell your broker which shares you want to sell (for example, "the shares I bought on July 5, 2012, for $11 each").
At Schwab, if you place the order online, you'll see your cost basis method on the order entry screen. If you select the "specified lots" method, you'll be able to specifically identify which lots you want to sell.
Cost basis options for mutual funds
Mutual fund investors have one additional cost basis method they can use called "average cost, single category." This method determines your transaction's cost basis by taking the average cost of all the shares you own and multiplying it by the number of shares you're selling. This method provides the simplest way to handle mutual fund sales when you're reinvesting dividends and/or regularly adding to your holdings.
There is one major downside to using the average cost method. If you choose this method for your first sale, you must continue to use it for every subsequent sale for shares that were acquired before that sale date. Whereas, opting for specific identification would allow you to pick and choose which shares to sale, potentially saving you money.
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."
Let's look at an example of how this works. Say you have 1,000 shares of a mutual fund and your lowest-cost shares were purchased for $10, your highest-cost shares were purchased for $100 and your average cost per share is $50. Today the market value of your mutual fund shares is $60, and you want to sell 100 shares. We'll ignore commissions here to keep it simple.
Let's compare the three ways your cost basis could be calculated (FIFO, average cost, and specific identification) and see what the taxable gain is in each hypothetical scenario.
Your cost basis can help you book a gain or loss
|Method||Purchase price||Sale price||Capital gain/loss|
($50 x 100 shares)
|Average cost, single category||$50*||$60||
($10 x 100 shares)
(-$40 x 100 shares)
As you can see in the table above, depending on the cost basis method you choose, your taxable gain or loss can vary greatly. Each of these transactions results in the same pre-tax cash flow of $6,000. However, depending on your particular situation, the money you have left in your pocket after taxes could be quite different in each method.
So, which method should you choose?
One cost basis method is not necessarily better than another since each has its benefits and down sides. Choosing the best cost basis method depends on your specific financial situation and needs.
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 mutual fund sales and the FIFO method for your other investments is probably fine.
But if you're a tax-sensitive investor, specific identification could potentially save you a lot in taxes—especially if you use other tax-smart strategies, such as tax-loss harvesting, tax-gain harvesting, or donating appreciated assets to your favorite charity.
Whichever method you decide to use, it's important to plan ahead so you aren't stuck with a huge tax bill come filing season.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment or tax advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.1021-1N1A