Save on Taxes: Know Your Cost Basis

Each time you sell an investment in your taxable brokerage account, there's the potential to create income from a capital gain. If you're not paying attention to the cost basis and holding period of the investments you sell, you could face an unexpected taxable event. Fortunately, there are numerous cost basis methods to choose from. At the same time, no single method works best in every situation.

Simply put, your cost basis is what you paid for an investment. It includes brokerage fees, "loads" (i.e., one-time commissions that some fund companies charge whenever you buy or sell shares in mutual funds), and other trading costs, and it can be adjusted to reflect corporate actions, such as mergers and stock splits.

Cost basis matters because it's the starting point for any calculation of a gain or loss. If you sell an investment for more than its cost basis, you'll have a capital gain. If you sell it for less, it's a loss. Calculating your cost basis is generally pretty straightforward, but there are exceptions. For example, if you buy multiple blocks of the same investment, like through a dividend reinvestment plan, each block will likely have a different cost basis and holding period.

Note, 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. To learn more about the unique tax rules for bonds, see this article, "Your Guide to Bond Taxes."

When you open a brokerage account a default cost basis method is assigned to your investments. The default method put in place will depend on the brokerage firm you have an account with. For Schwab clients with accounts opened before October 2024, the average cost method was the default for mutual funds. Beginning in October 2024, newly opened accounts that hold mutual funds will use first-in, first-out (FIFO) as the default method. For all other security types, the FIFO method is the default. From a tax perspective, the default cost basis methods often provide sub-optimal results, because they're not tailored to each investor's particular needs.

Listed below are the cost basis methods offered to Schwab clients, but be aware, other firms may have different options, which are not covered here.

The average cost basis method is generally available for all mutual funds (including open- or closed-end funds), exchange-traded funds (ETFs), and exchange-traded notes (ETNs). Average cost is calculated by taking the total cost of the shares you own and dividing by the total number of shares. Be aware, if you use this method for cost basis reporting, you must use it for all shares bought before that initial stock sale.

FIFO automatically assumes you're selling shares you held the longest. 

LIFO assumes the shares most recently purchased are the first ones sold.

With the low-cost lot method, shares with the lowest cost basis are sold first.

Using the high-cost lot method, shares with the highest cost basis are sold first.

The Tax Lot Optimizer uses an algorithm to calculate the optimal way to minimize the tax impact of each sale. In general, the goal is to sell investments for losses first (short-term losses, then long-term losses) and gains last (long-term gains, then short-term gains).

When placing a sell order, you can identify which specific lots of shares to sell. Unfortunately, this specified lot method can't be set as your account default because it can't be automated; it requires you to manually select each share you want to sell. The advantage is the method is that it allows the greatest control over the realization of gains and losses.

Say you bought 500 shares of the XYZ fund 10 years ago for $10 per share for a total cost of $5,000 (for the sake of simplicity, we'll ignore commissions on all the trades). Five years later, you bought a second block of 500 shares for $60 per share ($30,000 total). Finally, 10 months ago, you bought 200 shares for $65 each ($13,000 total).

Today, the fund's share price is trading at $100, and you decide to sell 100 shares. You're currently in the 15% long-term capital gain tax bracket and 24% short-term capital gain tax bracket. You want to minimize the taxes on this transaction, so which cost basis method should you choose?

In this example, the Tax lot Optimizer and specified lot methods produced the lowest taxes due of $600 (in green) compared to the least tax-efficient methods of FIFO and low-cost with taxes of $1,350 (in red). Notice how the smallest capital gains were realized using the LIFO and high-cost methods ($3,500); however, the taxes were not the lowest at $840. This is because the methods are realizing short-term capital gains, which are taxed at a higher rate.

But remember, this is just an example. To determine the best methods for your particular situation, consider meeting with a financial or tax advisor.

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 lot method, you'll be able to specifically identify which shares you want to sell.

To change your default cost basis method, log in to your Schwab.com account and select your account icon in the upper right corner and select Account Settings. This brings up a page where you can change your cost basis method for each of your accounts.

Because each investment you purchase could have a different cost basis and holding period, no single automated cost basis method will work perfectly in every situation. Each method has its benefits and downsides, depending on what you're trying to accomplish.

Generally, we suggest investors specifically identify the shares they want to sell on every trade, because this offers the most control over the gain or loss realized. The specified lot method offers the potential to maximize tax efficiency—especially if you use other tax-smart strategies, such as tax-loss harvesting, tax-gain harvesting, or donating appreciated assets to your favorite charity.

If you're looking for a cost basis method that is automated, and you also want to minimize taxes, we generally suggest using the Tax Lot Optimizer. This method can offer a high level of tax efficiency but with less effort of selecting each individual share to sell.

Whichever method you decide to use, it's important to plan ahead, so you aren't stuck with a huge tax bill come tax season. To truly maximize the tax benefits of each method, its best to work with a tax professional and/or wealth manager who can help you implement a holistic tax and financial plan.