What Is the Best Cost Basis Method for Mutual Funds?

An investor’s cost basis in a mutual fund is the original value of their shares for tax purposes, including the purchase price plus any commissions or fees. When you sell shares, the difference between the sale price and your cost basis determines the capital gain or loss. For investors who have made multiple purchases over time at different prices, the accounting method chosen to identify which shares are sold directly influences the amount of tax owed on the transaction.

Understanding the Cost Basis Methods

First-In, First-Out (FIFO)

The First-In, First-Out (FIFO) method assumes the first shares you purchase are the first shares you sell. This is often the default accounting method used by brokerage firms if an investor does not select another option. For example, if you bought 50 shares at $10 in January and another 50 shares at $15 in June, selling 50 shares under FIFO means you are selling the January shares. Your cost basis for this sale would be $500 (50 shares x $10).

In a rising market, this can result in selling shares with the lowest cost basis, which may have been held long enough to qualify for long-term capital gains tax rates.

Specific Share Identification (Spec ID)

The Specific Share Identification (Spec ID) method allows you to choose the exact lot of shares you wish to sell at the time of the transaction. This lets you strategically manage the sale’s outcome to minimize gains or realize losses. Using the previous example, if the market price is $18, you could use Spec ID to sell the 50 shares bought at $15. This results in a capital gain of $150 (50 shares x ($18 – $15)), much lower than the gain under FIFO.

Using Spec ID requires you to specify which lot you are selling when you place the trade order.

Average Cost

The Average Cost method, unique to mutual funds and dividend reinvestment plans (DRIPs), simplifies calculations by averaging the purchase price of all shares owned. To find the average cost, divide the total amount invested by the total number of shares. For example, if you own 250 shares with a total cost of $2,750, your average cost per share is $11. If you sell 100 shares, your cost basis for the sale is $1,100 (100 shares x $11).

According to IRS rules, once you use the Average Cost method for a fund, that choice is binding for all sales of shares from that account. You can revoke this election for new shares by notifying your brokerage in writing, but all shares purchased before the revocation will retain their averaged basis.

Comparing Methods for Tax Optimization

To illustrate the tax impact, assume you made three purchases: 100 shares at $20 (Year 1), 100 shares at $30 (Year 2), and 100 shares at $25 (Year 3). In Year 4, you sell 100 shares when the price is $28.

With the FIFO method, you sell the Year 1 shares, resulting in a long-term capital gain of $800 (100 shares x ($28 – $20)). With the Average Cost method, your average basis is $25 per share (($2000 + $3000 + $2500) / 300 shares). Selling 100 shares creates a taxable gain of $300 (100 shares x ($28 – $25)).

For Minimizing Taxable Gains

To minimize the immediate tax impact of a sale, use the Specific Share Identification method to sell shares with the highest cost basis. In the previous example, you would sell the 100 shares purchased in Year 2 for $30 each. Selling these at the current $28 price results in a capital loss of $200 (100 shares x ($28 – $30)).

This loss can be used to offset other capital gains or up to $3,000 of ordinary income annually, reducing your overall tax liability.

For Tax-Loss Harvesting

Specific Share Identification is the most effective method for tax-loss harvesting, which involves selling investments at a loss to offset gains. It allows you to pinpoint and sell specific lots of shares that have declined in value. For example, selling the shares bought at $30 when they are trading at $28 locks in a loss for tax purposes.

Be mindful of the “wash sale” rule, which prohibits claiming a loss if you buy the same or a “substantially identical” security within 30 days before or after the sale.

For Simplicity

For investors who prioritize simplicity, FIFO and Average Cost are the most straightforward options. FIFO is easy to manage as it is often the brokerage’s default setting, but it can be tax-inefficient by forcing the sale of the oldest, lowest-cost shares. The Average Cost method is also simple because it consolidates all purchase prices into one figure, eliminating the need to track individual lots. However, choosing this method removes the ability to use Spec ID for those shares in the future, limiting tax-planning flexibility.

Implementing Your Cost Basis Method

Implementing your chosen cost basis method may require action. Brokerages often default to FIFO, but you can usually set a different preferred method for future sales in your account settings. For the Specific Share Identification method, you must act at the time of each sale.

When placing a trade, you must provide instructions identifying the exact shares to be sold by purchase date and cost. Most online trading platforms have a workflow for selecting the specific tax lot before you confirm the sale.

Tax Reporting

Your brokerage reports sale proceeds and cost basis information to you and the IRS on Form 1099-B. This form details your transactions, separating them into short-term (held one year or less) and long-term (held more than one year). You will use the information from Form 1099-B to complete IRS Form 8949, Sales and Other Dispositions of Capital Assets.

The totals from Form 8949 are then carried over to Schedule D, which is filed with your Form 1040 tax return.

Record-Keeping

Maintaining personal records is an important part of investing. Brokerages must track and report the cost basis for “covered” shares, which for mutual funds are those purchased on or after January 1, 2012. However, they are not required to report the basis for “non-covered” shares purchased before that date, making you responsible for tracking it.

Your records should include all purchase dates, shares bought, price per share, and any reinvested dividends or capital gains distributions, as these add to your cost basis. These records are needed to calculate gains or losses accurately and to verify the information your broker reports.