How to Calculate the Cost Basis for Mutual Funds Over a Long Time Period

Calculating the cost basis of an investment is important for tax purposes

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.

Key Takeaways

  • Cost basis is the historical acquisition price assigned to your investment for tax purposes.
  • For mutual funds, you can determine your cost basis using the FIFO method or average cost method.
  • Under the FIFO method, the first share you bought is the first share you sell.
  • Under the average cost method, your cost basis is the average of either your short-term or long-term holdings.
  • Cost basis directly ties into how much capital gains taxes you report. Higher cost basis results in lower taxes, while lower cost basis results in higher taxes.

Cost Basis Basics

Cost Basis Example

Assume you currently own 120 units of a mutual fund. Your investment was made 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. However, 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 $8.129 ($1,008/124 shares owned).

Methods for Calculating Cost Basis

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.

Reporting Requirements

It's your responsibility as taxpayer to report you gains and losses. You must file Schedule D with your Form 1040 to report gains or losses. In addition, you may need to file Form 8949 and list out sale transactions for the tax year.

The first in, first out method (FIFO) simply states that the first shares purchased are also the first ones to be sold first. Subsequently, each investment in the fund has its owncost basis. In the example above, the first share you purchased at $8 is the cost basis if you sell one share.

The FIFO method is more advantageous for investors looking to capitalize on long-term investment benefits. Investments held for more than one year often have more favorable tax benefits such as lower capital gains tax rates. Opting to use the FIFO method often results in lower taxes paid when the shares were purchaesd over one year ago as opposed to selling shares acquired within the past year.

High vs. Low

You will likely pay less taxes when you have a higher cost basis. This is because the difference between what you bought an investment for and what you sold it for (your profit) will be smaller.

Alternatively, a low cost basis might mean you successfully got into an investment early. However, you'll likely be charged higher capital gains taxes since your profit on your investment is higher.

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.

The average cost method is often easier to calculate as it does not require specific identification of shares purchased or sold. However, by averaging the historical cost, taxpayers may end up with a lower cost basis for certain transactions resulting in higher capital gains.

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.

How Is Cost Basis Calculated for Mutual Funds?

The cost basis for mutual funds is calculated by either using the FIFO method to identify the first shares purchased or the average cost method which aggregates the average price of shares. Under the average cost method, you must track the average cost of short-term shares (purchased within the past year) separately from long-term shares (held for more than one year).

What Cost Basis Method Is Best to Use for Mutual Funds?

Each cost basis will result in different potential capital gains. You may receive the greatest tax benefit under FIFO if the price of mutual fund has decreased over time as your cost basis for the first shares purchased will be highest.

Alternatively, your capital gains taxes due will be lower under the average cost method if the price of the mutual fund has increased. Instead of having a low cost basis when you first bought in, this method allows you to average your cost and leverage potentially higher shares acquired later.

Do You Want a High or Low Cost Basis?

When determining capital gains taxes due to the IRS, it is more favorable to have a high cost basis. A higher cost basis means there is a smaller difference between what you paid for the security and what you sold it for. A high cost basis may also signify you didn't make as large of a profit on your investment, though.

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