Average Cost Basis
The average cost basis method determines the per-share cost of a mutual fund holding in a taxable account by dividing the total dollars invested by the number of shares owned. That average is compared with the sale price to calculate capital gains or losses for tax reporting.
How it works
- Formula: Average cost per share = Total dollars invested ÷ Total shares owned.
- Example: If you invested $52,000 and own 3,500 shares, the average cost is $52,000 ÷ 3,500 = $14.86 per share.
- If you sell 1,000 shares at $25, gain = (25 − 14.86) × 1,000 = $10,140.
Adjustments such as stock splits, reinvested dividends, and returns of capital change the cost basis and must be reflected in the calculation.
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Other common cost-basis methods
Different methods can produce very different tax outcomes. You must select and report a cost-basis method with your broker; many brokers default to average cost for mutual funds.
- First In, First Out (FIFO)
- Sells the oldest shares first.
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Often produces long-term gains if older lots were held more than one year (long-term capital gains are typically taxed at lower rates than short-term gains).
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Last In, First Out (LIFO)
- Sells the most recently acquired shares first.
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May produce short-term gains if recent shares were held one year or less (taxed at ordinary income rates).
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High-cost (highest-in)
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Sells shares with the highest purchase price first to minimize realized gains (or maximize realized losses).
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Low-cost (lowest-in)
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Sells shares with the lowest purchase price first, which may maximize realized gains.
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Specific identification
- You specify which lots are sold (e.g., sell particular purchase lots to manage tax outcomes).
- Requires precise recordkeeping and clear instructions to your broker at the time of sale.
Example comparison
Using the earlier holdings (1,000 @ $30; 1,000 @ $10; 1,500 @ $8; total 3,500 shares; average cost $14.86), selling 1,000 shares at $25 yields:
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- Average cost: gain = (25 − 14.86) × 1,000 = $10,140
- FIFO (oldest @ $30): (25 − 30) × 1,000 = −$5,000 (a loss)
- LIFO (newest @ $8): (25 − 8) × 1,000 = $17,000 (a larger gain)
- High-cost: same as FIFO here = −$5,000
- Low-cost: same as LIFO here = $17,000
Choice of method can change whether you realize a gain or loss and whether gains are taxed at long-term or short-term rates.
When cost basis matters
- Only relevant for holdings in taxable accounts and when you sell (especially partial sales).
- For mutual funds, brokers typically provide annual tax reports using the elected method.
- Once elected for a specific fund, you generally must continue using that method for that fund unless you make a permitted change and follow required procedures.
Practical tips
- Match the method to your tax objectives (minimizing current tax vs. realizing gains).
- Use specific identification if you want maximum flexibility, but keep meticulous records and notify your broker when selling.
- Review trade-offs: locking in a gain now may cost taxes today, while deferring could risk future price changes.
- Consult a tax advisor or financial planner for guidance tailored to your situation.
Quick checklist
- Choose and report a cost-basis method to your broker.
- Track reinvested dividends, splits, and return-of-capital adjustments.
- Consider capital gains timing (short-term vs. long-term) when planning sales.
- Keep records if using specific identification.
Conclusion: Average cost basis simplifies mutual fund tax reporting by averaging purchase prices across all shares, but other methods (FIFO, LIFO, high-cost, low-cost, specific identification) can lead to materially different tax results. Select the method that fits your tax strategy and maintain accurate records.