Let’s say you’ve been regularly buying shares in a booming tech company over the past few years, but now you want to start taking some of those profits. Your brokerage makes it easy-peasy: Just choose the number of shares you want to unload and click the “sell” button. But investors can end up paying more in taxes than they have to if they aren’t smart about choosing which of their shares to sell based on a factor known as cost basis.
“Choosing the right cost basis method helps you keep more money in your pocket,” explains Nilay Gandhi, a certified financial planner with Vanguard Personal Advisor Services.
The cost basis is the price you paid for an investment. Whenever you sell shares held in a taxable account, your cost basis determines the size of your gain or loss, as well as your capital gains tax liability. The process can get tricky if you have been steadily buying shares of the same companies or funds over time.
Because prices go up and down, you paid a different price each time you made a purchase. Each separate purchase of a security in a single transaction is called a tax lot. The size of your tax-reportable gain (or loss) will depend on which lots you sell.
If you sell lots purchased more than a year ago for a profit, you could pay up to 20 percent in federal long-term capital gains tax, depending on your tax bracket. Selling lots you purchased within the past year for a profit could incur short-term federal capital gains tax of up to 37 percent.
Unless you change your brokerage’s default settings, whenever you sell part of a holding, most major brokerages will typically sell the oldest lots first or report your average overall cost to the IRS. That’s an OK start, but most brokerages offer other options that can reduce your taxes even more, says Allan Roth, a Colorado-based certified public accountant and financial adviser.
- Average. This method, which averages all your purchase prices of the same investment, is typically reserved for mutual funds. The IRS does not allow it for most stock sales.
- First In, First Out (FIFO). This method automatically sells the oldest lots first.
- Highest In, First Out (HIFO). This strategy sells the lots that you paid the most for. That can be advantageous for anyone trying to limit their capital gains and maximize their tax losses, says Gandhi.
- Lowest Cost, First Out (LCFO). This method sells the investments with the biggest gains first. Like HIFO, LCFO does not take into account the date of the purchase, so it may expose users to liabilities for short-term capital gains tax.
- Tax-optimized Methods. Most brokerages offer at least one sophisticated automatic cost basis option that takes into account timing and returns to avoid short-term capital gains taxes and maximize tax losses.
