Let's say you've been regularly buying shares in a booming tech company over the past few years, but now you want to start taking some of those profits, perhaps to rebalance your portfolio. Your brokerage makes it easy-peasy: Just choose the number of shares you want to unload and click the "sell" button. Now you can celebrate your investing win!
You may not realize it, but the IRS might be celebrating, too. That's because investors can end up paying more of their gains in taxes than they have to if they aren't smart about choosing which of their shares to sell based on a factor known as cost basis.
Rather than being solely about what you make, "investing is about what you keep," explains Nilay Gandhi, a certified financial planner with Vanguard Personal Advisor. "Choosing the right cost basis method helps you keep more money in your pocket."
In concept, cost basis is simple: It's the price you paid for an investment. It isn't a worry for transactions made in tax-protected accounts, such as IRAs. Money withdrawn from those accounts is typically taxed at ordinary income rates. Whenever you sell shares held in a taxable account, however, your cost basis determines the size of your gain or loss, as well as your capital gains tax liability. The process can get tricky if you have been steadily buying shares of the same companies or funds over time.
Because prices go up and down, you paid a different price each time you made a purchase. Each separate purchase of a security in a single transaction is called a tax lot. So when it comes time to sell some of your holdings, the size of your tax-reportable gain (or loss) will depend on which lots you sell.
If you sell lots purchased more than a year ago for a profit, you could pay anywhere from no tax to 20% in federal long-term capital gains tax, depending on your tax bracket. (You might owe more to your state if it taxes capital gains.)
Selling lots you purchased within the past year for a profit could incur short-term federal capital gains tax of up to 37%, as well as possible state tax. In addition, any gain, whether short term or long term, could boost your income enough to expose you to other taxes or costs – such as the federal net investment income tax of 3.8%. Losses, on the other hand, can be used to offset gains and reduce your tax bill.
Unless you change your brokerage's default settings, whenever you sell part of a holding, most major brokerages will typically either sell the oldest lots first or report your average overall cost to the IRS. That's an okay start, but most brokerages offer other options that can reduce your taxes even more, says Allan Roth, a Colorado-based certified public accountant and financial adviser.
Choose your cost basis options wisely
Roth's preferred method is to select which lots to sell himself so that he can exactly tailor his gains or losses to that year's tax situation. To do that, you must go into your brokerage's account settings and switch the cost basis default to the fully personalized option, which goes by slightly different names at different brokerages, such as "specified lots" at Charles Schwab, "specific shares" at Fidelity and "specific identification" at Vanguard.
Before any sale, decide exactly which lots will give you the optimal combination of gains and losses, and only then direct the brokerage to sell your chosen lots.
How cost basis is calculated
For investors who don't want to spend time on such precise machinations, brokerages offer several other automatic cost basis methods that advisers say can help reduce tax liabilities. To make sure you are taking advantage of the option that's best for you, log in to your brokerage account and check (and possibly change) your cost basis default setting before you make any sale, Roth stresses.
"The IRS doesn't allow do-overs," he says. There are more than a dozen cost basis methods. Here are five of the most popular and useful options, listed alphabetically:
Average. This method, which averages all your purchase prices of the same investment, is typically reserved for mutual funds. It's the default fund option at some major brokerages, including Fidelity and Vanguard. The IRS does not allow you to use it for most stock sales. The average method is one of the simpler methods and can be a reasonable option for longtime fund investors who expect their capital gains, income and tax rates to remain stable.
First In, First Out (FIFO). This method automatically sells the oldest lots first. It is the default option for all holdings on E*Trade, Robinhood and many other brokerages, and it is the default option for stocks and exchange-traded funds at Fidelity, Schwab and Vanguard.
In a generally rising market, FIFO makes it more likely that any capital gains will be long term. Josh Trubow, a certified financial planner in Waltham, Massachusetts, notes that this option doesn't guarantee the lowest tax bill, but it can be a reasonable choice for investors wishing to donate highly appreciated stock.
It can also work for investors whose income – after the gains are added – keeps them in a low capital gains bracket. For example, for 2024, married couples filing jointly who have taxable income below $94,050 pay no federal long-term capital gains taxes. It may also make sense to take gains now if you think your tax rate will be higher in the future, Trubow adds.
Highest In, First Out (HIFO). This strategy sells the lots that you paid the most for. That can be advantageous for anyone trying to limit their capital gains and maximize their tax losses, says Vanguard's Gandhi. But, he warns, this method does not take into account the date you made the purchase. If using this method results in selling for a profit some shares bought within the past 12 months, you could face higher short-term capital gains rates.
Lowest Cost, First Out (LOFO). This method sells the investments with the biggest gains first. Like HIFO, LOFO does not take into account the date of the purchase, so it may expose users to liabilities for short-term capital gains tax. And like FIFO, it can be a reasonable option for those designating appreciated shares to donate, or for those currently in low tax brackets or who expect their tax rates to be higher in future years.
Tax-optimized. Most major brokerages offer at least one sophisticated automatic cost basis option that takes into account both timing and returns to avoid short-term capital gains taxes and maximize tax losses. E*Trade calls its version "Minimum Tax Impact," Fidelity's version is "Tax-sensitive," Schwab's is called "Tax Lot Optimizer," and Vanguard's is "Minimum Tax."
Roth, who works with clients who use a few major platforms, says he hasn't noticed significant differences in the results of the different tax-optimized methods at the brokerages. Although he still prefers designing his cost bases himself, he says the brokerages' automatic tax-minimizing options are a good compromise.
Note: This item first appeared in Kiplinger Personal Finance Magazine, a monthly, trustworthy source of advice and guidance. Subscribe to help you make more money and keep more of the money you make here.
