What Is the Best Cost Basis Method for Mutual Funds?

When you sell shares in a mutual fund, the profit you make is subject to capital gains tax. To determine that profit, you must first establish your cost basis, which is the original value of the shares for tax purposes. This figure includes the purchase price plus any additional costs like commissions or load fees. The difference between the sale price and your cost basis is your capital gain or loss. The method you use to calculate this basis can significantly alter your tax liability, making the choice of method an important financial decision.

Understanding the Default Method Average Cost

The average cost method simplifies tax reporting for investors who make multiple purchases of the same fund. To calculate it, divide the total dollar amount spent to acquire all shares by the total number of shares you own. This gives an average cost per share to use as the basis for shares you sell.

Consider an investor who buys 100 shares of a fund at $10 per share and later buys another 100 shares at $12. Their total investment is $2,200 for 200 shares, making the average cost $11 per share. If they sell 50 shares, their cost basis for the sale is $550 (50 shares x $11).

The main benefit is simplicity, as it eliminates the need to track individual purchase lots and smooths out price variations. It provides a middle-of-the-road tax outcome. If you use the average cost method, you must continue to use it for all shares in that fund.

Exploring First-In, First-Out (FIFO)

An alternative is the First-In, First-Out (FIFO) method, where the first shares you acquire are considered the first shares you sell. This method is straightforward but can have significant tax consequences depending on market conditions.

Using the same purchase history, if an investor sells 50 shares, FIFO dictates that these shares must come from the first lot purchased at $10. The cost basis for this sale would be $500 (50 shares x $10).

In a rising market, the oldest shares usually have the lowest cost basis. Selling them first under FIFO often results in recognizing the largest possible capital gain and a higher tax bill. This method offers no flexibility for tax planning.

Using the Specific Identification Method

The Specific Identification (Spec ID) method allows you to choose which specific lots of shares to sell. This gives you direct control over the amount of capital gain or loss you realize from a transaction. This method requires more detailed record-keeping but offers the most flexibility for tax management.

To use this method, you must instruct your broker on which shares to sell before the trade settles, otherwise the broker’s default method will apply. For example, if an investor holds lots purchased at $10, $12, and $15, they could sell the $15 shares to realize the smallest gain. This control also makes Spec ID useful for tax-loss harvesting, where shares are sold at a loss to offset other capital gains.

How to Select and Report Your Method

You can select a default cost basis method for your account with your brokerage firm, often online or by submitting a form. If you do not make a selection, the firm will assign its default, which is often FIFO for uniformity across all security types. You should verify the default method with your specific brokerage.

When you sell shares, your broker issues Form 1099-B, which reports the sale to you and the IRS. This form distinguishes between “covered” and “noncovered” shares. For covered securities, which are those acquired after January 1, 2012, for mutual funds, the broker must report the cost basis. For noncovered shares purchased before this date, the taxpayer is responsible for this calculation.

The information from Form 1099-B is used to complete IRS Form 8949, Sales and Other Dispositions of Capital Assets. On this form, you list the details of each sale, including the proceeds, cost basis, and gain or loss. The totals from Form 8949 are then transferred to Schedule D, Capital Gains and Losses, which is filed with your tax return.