What is the 'Average Cost Basis Method'
The average cost basis method is a system of calculating the cost basis on mutual fund positions held in a taxable account to determine the profit or loss on them. The average cost basis method adds up the cost basis for the entire position in a specific mutual fund and divides it by the total number of fund shares owned to arrive at an average cost per share. The average cost is then compared with the price at which the fund shares were sold to determine gains or losses. The average cost basis is one of three methods that the IRS allows investors to use to arrive at the cost of their mutual fund holdings acquired before Jan. 1, 2012.
BREAKING DOWN 'Average Cost Basis Method'
Apart from the average cost basis method, investors can use the FirstIn FirstOut (FIFO) method and the specific identification method to calculate the cost of mutual fund holdings acquired before Jan. 1, 2012. For mutual funds acquired after that date, additional cost basis methods can be used, such as Lastin FirstOut (LIFO) and HighCost FirstOut (HIFO).
While most brokerages report the cost basis for mutual funds using the average cost method, investors can elect to change to one of the other methods if they so choose. This election should be done before the actual sale of the fund units and can be changed later if desired.
In consultation with their tax advisor or financial planner, investors should decide on the cost basis method that will minimize their tax bill if they have substantial mutual fund holdings in taxable accounts. This is because the default average cost basis method may not always be the optimal method from a taxation point of view. Note that the cost basis only becomes important if the holdings are in a taxable account and the investor is considering a partial sale of the holdings.
For example, assume that an investor made the following fund purchases in a taxable account over a time period prior to January 2012: 1,500 shares at $20, 1,000 shares at $10 and 1,250 shares at $8. The investorâ€™s average cost basis is thus $13.33 (i.e. $50,000/3,750 shares).
Suppose the investor then sells 1,000 shares of the fund at $19. The capital gain/loss computed under two different methods stack up as follows:
 Gain/loss using average cost basis = ($19  $13.33) x 1,000 shares = $5,667
 Gain/loss using FIFO = ($19  $20) x 1,000 shares =  $1,000
In this case, the investor would be much better off if he or she had selected the FIFO method to determine the cost basis prior to selling the shares, since it results in a tax loss of $1,000, compared with a taxable gain of $5,667 under the average cost basis method.

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