Investors must pay taxes on any investment
gains they realize. Subsequently, any capital gain realized by an investor over the course of a year must be identified when they file their income taxes. For this reason, being able to accurately calculate the cost basis of an investment, particularly one in a mutual fund, becomes extremely important.
The cost basis represents the original value of an asset that has been adjusted for stock splits, dividends and capital distributions. It is important for tax purposes because the value of the cost basis will determine the size of the capital gain that is taxed. The calculation of cost basis becomes confusing when dealing with mutual funds because they often pay dividends and capital gains distributions usually are reinvested in the fund.
For example, assume that you currently own 120 units of a fund, purchased in the past at a price of $8 per share, for a total cost of $960. The fund pays a dividend of $0.40 per share, so you are due to receive $48, but you have already decided to reinvest the dividends in the fund. The current price of the fund is $12, so you are able to purchase four more units with the dividends. Your cost basis now becomes $8.1290 ($1008/124 shares owned).
When shares of a fund are sold, the investor has a few different options as to which cost basis to use to calculate the capital gain or loss on the sale. The first in, first out method (FIFO) simply states that the first shares purchased are also the ones to be sold first. Subsequently, each investment in the fund has its own cost basis. The average cost single category method calculates the cost basis by taking the total investments made, including dividends and capital gains, and dividing the total by the number of shares held. This single cost basis then is used whenever shares are sold. The average cost double category basis requires the separation of the total pool of investments into two classifications: short term and long term. The average cost is then calculated for each specific time grouping. When the shares are sold, the investor can decide which category to use. Each method will generate different capital gains values used to calculate the tax liability. Subsequently, investors should choose the method that provides them with the best tax benefit.
To learn more, see Selling Losing Securities For A Tax Advantage, Using Tax Lots: A Way To Minimize Taxes and Mutual Fund Basics Tutorial.

What is an adjusted cost basis and how is it calculated?
Learn what adjusted cost basis is, how it is calculated, and why this metric is important for investors, business owners ... Read Answer >> 
What are the main methods for calculating business costs?
See why different economic actors use different methods for calculating costs, and learn how different methods can impact ... Read Answer >> 
What cost basis reporting rules are set by the Internal Revenue Service (IRS)?
Read about the cost basis reporting regulations imposed by the Internal Revenue Service and some options available to individual ... Read Answer >> 
Will I be taxed heavily on capital gains from the sale of gifted stock I didnâ€™t pay ...
Background: My father transferred (gifted) shares of DUK stock into my name when I was born in 1988. This stock grew from ... Read Answer >> 
Should mutual fund dividends be reinvested?
Learn the advantages and disadvantages, as well as the tax impact, of having your mutual fund dividends automatically reinvested ... Read Answer >> 
How do I calculate my gains and/or losses when I sell a stock?
To begin, you need to know your cost basis, or the price you paid for the stock. If you did not record this information, ... Read Answer >>

Investing Basics
What Determines Your Cost Basis?
In any transaction between a buyer and seller, the initial price paid in an exchange for a product or service will qualify as the cost basis. When it comes to securities and related financial ... 
Mutual Funds & ETFs
How TaxEfficient Is Your Mutual Fund?
Learn about factors that influence the taxefficiency of your mutual fund, how income from your investment is taxed and what to look for when choosing a fund. 
Investing Basics
Cost Basis Basics
The term "cost basis" refers to the original value of a security you own. When you sell a stock, bond or mutual fund, you use the cost basis to determine your profit or loss, which in turn affects ... 
Mutual Funds & ETFs
Understanding Taxes on Mutual Funds Dividends
Learn about the basics of mutual fund dividend taxation, including how and why mutual funds pay dividends and when different tax rates apply to dividend income. 
Mutual Funds & ETFs
How to Find Mutual Funds With High Dividends
Learn about the important factors to consider when looking for mutual funds that pay high dividends, including how they may impact your taxes. 
Taxes
Capital Gains Tax 101
Find out how taxes are applied to your investment returns and how you can reduce your tax burden. 
Investing News
Understanding How Mutual Funds Pay Dividends
The process by which mutual fund dividends are calculated, distributed and reported is fairly straightforward in most cases. Here's a look. 
Financial Advisors
How to Navigate Taxable Mutual Fund Distributions
It's almost time for yearend capital gains distributions for mutual funds. Here's how to monitor them and minimize their tax impact. 
Taxes
Comparing LongTerm vs. ShortTerm Capital Gain Tax Rates
Learn about the difference between short and longterm capital gains and how the duration of your investment can impact your tax liability. 
Financial Advisors
Tax Efficient Strategies for Mutual Funds
Before you sell mutual fund shares, consider these tax strategies first.

Average Cost Basis Method
A system of calculating the cost basis on mutual fund positions ... 
Capital Gain
1. An increase in the value of a capital asset (investment or ... 
Yield On Cost  YOC
The annual dividend rate of a security divided by the average ... 
Reinvestment
Using dividends, interest and capital gains earned in an investment ... 
Mutual Fund Yield
Dividend payments divided by the value of a mutual fundâ€™s shares. ... 
IRS Publication 564: Mutual Fund Distributions
A document published by the Internal Revenue Service (IRS) that ...