Understanding cost basis and taxes
If you sold a stock, bond, or mutual fund last year, you'll need to report any capital gain or loss you incurred to the IRS at tax time. To calculate your gain or loss, you need to know the cost basis of your investments.
Cost basis is a relatively straightforward concept—it's what you actually paid for an investment. It's good to know the cost basis of your investments so that when you're ready to sell, you can accurately measure your gain or loss.
There are a few different ways to calculate the cost basis of your investments. No one method is objectively better than another. The right choice for you will depend on your tax strategy, how hands-on you want to be, and how your cost basis method might affect your potential tax liability. By taking a little time to understand your cost basis options, you can choose the one that best fits your needs.
What's cost basis?
Simply put, cost basis is the amount you paid—including brokerage fees, loads, and any other trading cost—to purchase an investment. This often means the price at the time of original purchase, although in some cases you'll have an adjusted cost basis. For example, if you received dividends from an investment and those dividends were reinvested to purchase more shares, this would create a new tax lot with a new basis. If you use the average cost method, this new lot could then increase or decrease the average cost of the lots you hold. Corporate actions like stock splits or mergers can also result in an adjusted cost basis.
Any time you sell an investment, you'll look at the difference between the current market value and your cost basis to determine whether you've had a gain or a loss on the sale. A lower cost basis means you'll recognize a bigger gain, and a higher cost basis means you'll recognize a loss or simply a smaller gain. That's something to consider as you think about your overall tax strategy.
You'll also want to factor in the amount of time you've held an investment, since an asset you've held for over a year is considered a long-term investment and could be taxed at a lower rate than a short-term investment (something owned for less than one year).
What are your cost basis options?
Vanguard has 5 options for calculating cost basis:
- Minimum tax (MinTax).
- Specific identification (SpecID).
- Highest in, first out (HIFO).
- First in, first out (FIFO).
- Average cost basis (AvgCost).
Vanguard is required to report cost basis for covered shares to both you and the IRS. However, we won't report cost basis for noncovered shares to the IRS. We only report the proceeds of the sale, and you're responsible for reporting the basis. Otherwise, you could get taxed for the entire amount of the sale.
You can determine whether a share is covered or noncovered by the investment type and purchase date. Generally, mutual fund and ETF (exchange-traded fund) shares are considered noncovered if they were bought before January 1, 2012. Stock shares are considered noncovered if they were bought before January 1, 2011. You can find more details here.
We'll get into the specifics of each cost basis method below.
Minimum tax (MinTax)
The MinTax cost basis method automatically selects the lots of securities you sell in an attempt to minimize the income tax you'll owe for the current year. It's available for mutual funds, ETFs, and stocks. And because it's automated, our system takes the work out of your hands.
This method sells or transfers tax lots in the following order:
1. Short-term losses.
2. Long-term losses.
3. No gain or loss.
4. Long-term gain.
5. Short-term gain.
It's important to note that the MinTax method may not minimize the tax impact of every transaction, and the method's effectiveness at minimizing your taxes will vary depending on your individual circumstances.
Specific identification (SpecID)
This method gives you the most flexibility—if you're willing to put in the time. It's the only method that won't automatically select which shares to sell. With specific identification, you select the exact shares you want us to sell or transfer. This lets you estimate the potential tax impact of different scenarios. We try to make this method easier by giving you quick online access to the potential gain or loss for each share or lot.
This method could be a good fit for hands-on investors who are willing to do more upfront analysis and have complete long-term records, or those who are especially concerned about limiting tax liability. If you plan to use the SpecID method, you'll need to make sure you've selected this method in advance, confirmed the selection with Vanguard (which can take 1 business day), and located the necessary records.
Highest in, first out (HIFO)
HIFO offers an automated, hands-off approach, and because it sells the highest-cost shares first, it attempts to minimize any gains—or maximize any losses—for each individual transaction. With this method, shares with the highest cost are sold first, regardless of how long you've held the security.
Keep in mind that this method doesn't consider your holding period. It may sell shares with a short-term gain—triggering capital gains tax rates—before selling shares with a long-term gain. While your overall gain will be lower under this method, your tax due may not be minimized in all circumstances.
If you choose the HIFO method, Vanguard will continue to track noncovered mutual fund shares using average cost and sell them when the average cost basis is higher than the basis of any covered lot.
First in, first out (FIFO)
The FIFO method is relatively hands-off—you don't have to manually select which shares to sell since we'll automatically sell the oldest ones first. However, it can be less tax-efficient since sales and transfers are based on acquisition date and don't consider potential gains or losses.
With this method, your shares are sold in the same order you bought them, so the oldest shares go first. This method can be helpful if you hold both long-term and short-term tax lots, since shares held for more than 1 year are taxed at a lower rate by the IRS. It's available for all types of investments, and it's the default method for all investments other than mutual funds.
If you choose this method, please note that for any noncovered mutual fund shares you own Vanguard only keeps the average cost basis, so we can't assist you in determining each share's individual basis. If you plan to use the FIFO method, you'll need to use your own records to report your oldest lots on your tax return.
For all other noncovered shares, we'll first sell the shares for which we don't have an acquisition date, followed by the shares with the earliest acquisition date. As with noncovered mutual fund shares, we'll report the basis of the noncovered shares to you (if we know it), but won't send it to the IRS.
Average cost (AvgCost)
The default treatment for mutual funds is the average cost method. It’s the simplest of the methods listed here. The average cost method is automated, so you don't have to choose which shares to sell. Your gains or losses are spread evenly across all the shares you own.
If you're hoping to minimize your taxable gains—or maximize your tax losses to offset gains—this may not be your best choice. You'll have no control over the gains and losses realized on a sale or over the holding period between the purchase and sale of assets. Average cost lots will be distributed in the "first in, first out" order.
This method will also limit your ability to use a different tax calculation in the future. Once you've sold shares using the average cost method, the other shares you still hold will be "locked" into average cost going forward. You can change to a different method, but that would only apply to new purchases.
Since covered and noncovered shares are maintained separately according to IRS legislation, they'll have different average costs. If we don't have the basis for even 1 of the noncovered share lots, the average cost won't be calculated for noncovered shares. There'll still be an average cost available for covered shares.
What difference can cost basis make on your taxes?
Here's an example to illustrate the impact of different cost basis methods.
Let's say you purchased 100 shares of a stock at $50 each in January 2015, with a commission of $10. Then you purchased another 100 shares at $80 per share in March 2017, with a commission of $10. You've decided to sell 40 shares at the current market value of $100 each.
MinTax method: You'd be selling from the higher-cost batch of shares purchased at $80.10/share, 40 of which cost you $3,204. Your gain would be calculated at $796.
FIFO method: You'd be selling from the first batch of shares purchased at $50.10/share, 40 of which cost you $2,004. Your gain would be calculated at $1,996.
Average cost method: At $65.10/share, 40 shares would have cost you $2,604. Your gain would be calculated at $1,396.
Keep in mind that the best cost basis method for you may also depend on the type of transaction you're making and your tax strategy. For example: If you're selling shares, you may want to target depreciated shares to minimize capital gains. But if you're gifting or making an in-kind transfer, you may want to take the opposite approach and target the most appreciated shares.
It's your choice
As you can see, there are cost basis options for all types of investors and tax situations. By learning more about the different methods, you can choose the approach that best suits you.
Want to view or change your cost basis method?
Log in to vanguard.com. Then, from My Accounts, select Cost basis and then View/Change cost basis method. You can also select your cost basis method at the time of sale.
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All investing is subject to risk, including the possible loss of the money you invest.
This information isn't intended to be tax advice and can't be used to avoid any tax penalties. We recommend you consult a tax advisor.