Each time you sell an investment in your taxable brokerage account, there's the potential to create income from a capital gain. If you're not paying attention to the cost basis and holding period of the investments you sell, you could face an unexpected taxable event. Fortunately, there are numerous cost basis methods to choose from. At the same time, no single method works best in every situation.
What is cost basis?
Simply put, your cost basis is what you paid for an investment. It includes brokerage fees, "loads" (i.e., one-time commissions that some fund companies charge whenever you buy or sell shares in mutual funds), and other trading costs, and it can be adjusted to reflect corporate actions, such as mergers and stock splits.
Cost basis matters because it's the starting point for any calculation of a gain or loss. If you sell an investment for more than its cost basis, you'll have a capital gain. If you sell it for less, it's a loss. Calculating your cost basis is generally pretty straightforward, but there are exceptions. For example, if you buy multiple blocks of the same investment, like through a dividend reinvestment plan, each block will likely have a different cost basis and holding period.
Note, the cost basis for bonds can be a bit more complicated based on whether you bought them at "par" (face value), paid a premium, or got a discount. To learn more about the unique tax rules for bonds, see this article, "Your Guide to Bond Taxes."
Cost basis methods
When you open a brokerage account a default cost basis method is assigned to your investments. The default method put in place will depend on the brokerage firm you have an account with. For Schwab clients, the average cost method is the default for mutual funds, the first-in, first-out (FIFO) method is the default for all other securities. From a tax perspective, the default cost basis methods often provide sub-optimal results, because they're not tailored to each investor's particular needs.
Listed below are the cost basis methods offered to Schwab clients, but be aware, other firms may have different options, which are not covered here.
Average cost method
The average cost basis method is currently the default method for open-end mutual funds and is generally available for all mutual funds (including closed-end funds), exchange-traded funds (ETFs), and exchange-traded notes (ETNs). Average cost is calculated by taking the total cost of the shares you own and dividing by the total number of shares. Be aware, if you select this method for cost basis reporting, you must use it for all shares bought before that initial stock sale.
Method implications: The average cost basis method isn't necessarily the best or the worst option. As its name suggests, it'll generally produce "average" results from a tax perspective. However, simplicity makes it a good choice for those looking for a straightforward cost basis method. For example, average cost basis reporting can be useful it you reinvest dividends or regularly purchase additional shares of a specific fund.
Method implications: The average cost basis method isn't necessarily the best or the worst option. As its name suggests, it'll generally produce "average" results from a tax perspective. However, simplicity makes it a good choice for those looking for a straightforward cost basis method. For example, average cost basis reporting can be useful it you reinvest dividends or regularly purchase additional shares of a specific fund.
Method implications: The average cost basis method isn't necessarily the best or the worst option. As its name suggests, it'll generally produce "average" results from a tax perspective. However, simplicity makes it a good choice for those looking for a straightforward cost basis method. For example, average cost basis reporting can be useful it you reinvest dividends or regularly purchase additional shares of a specific fund.
" id="body_disclosure--media_disclosure--175256" >Method implications: The average cost basis method isn't necessarily the best or the worst option. As its name suggests, it'll generally produce "average" results from a tax perspective. However, simplicity makes it a good choice for those looking for a straightforward cost basis method. For example, average cost basis reporting can be useful it you reinvest dividends or regularly purchase additional shares of a specific fund.
First-in, first-out method (FIFO)
FIFO automatically assumes you're selling shares you held the longest. This is the default for all investments other than mutual funds.
Method implications: Because asset prices tend to rise over time, using FIFO as your cost basis method will have the oldest shares sold first, and those shares will often have the lowest cost basis. This means FIFO will generally result in higher capital gains being realized and potentially a larger tax liability. Also, FIFO doesn't specifically avoid short-term capital gains sales, which could result in a higher tax rate if a gain is realized.
Method implications: Because asset prices tend to rise over time, using FIFO as your cost basis method will have the oldest shares sold first, and those shares will often have the lowest cost basis. This means FIFO will generally result in higher capital gains being realized and potentially a larger tax liability. Also, FIFO doesn't specifically avoid short-term capital gains sales, which could result in a higher tax rate if a gain is realized.
Method implications: Because asset prices tend to rise over time, using FIFO as your cost basis method will have the oldest shares sold first, and those shares will often have the lowest cost basis. This means FIFO will generally result in higher capital gains being realized and potentially a larger tax liability. Also, FIFO doesn't specifically avoid short-term capital gains sales, which could result in a higher tax rate if a gain is realized.
Last-in, first-out method (LIFO)
LIFO assumes the shares most recently purchased are the first ones sold.
Method implications: Assuming shares are bought while prices are rising, selling the newest shares first will generally result in a highest cost basis and a lower capital gain from a sale. However, if the most recent shares were purchased within a year, the gains realized will be taxed at higher short-term capital gain rates.
Method implications: Assuming shares are bought while prices are rising, selling the newest shares first will generally result in a highest cost basis and a lower capital gain from a sale. However, if the most recent shares were purchased within a year, the gains realized will be taxed at higher short-term capital gain rates.
Method implications: Assuming shares are bought while prices are rising, selling the newest shares first will generally result in a highest cost basis and a lower capital gain from a sale. However, if the most recent shares were purchased within a year, the gains realized will be taxed at higher short-term capital gain rates.
Low-cost lot method
With the low-cost lot method, shares with the lowest cost basis are sold first.
Method implications: The low-cost lot method will result in the highest capital gain or lowest capital loss, which may result in a higher current tax burden. For that reason, the method generally isn't recommended for those trying to reduce their current year taxable income. In addition, this method doesn't specifically avoid short-term capital gains sales, which could result in a higher tax rate if a gain is realized.
Method implications: The low-cost lot method will result in the highest capital gain or lowest capital loss, which may result in a higher current tax burden. For that reason, the method generally isn't recommended for those trying to reduce their current year taxable income. In addition, this method doesn't specifically avoid short-term capital gains sales, which could result in a higher tax rate if a gain is realized.
Method implications: The low-cost lot method will result in the highest capital gain or lowest capital loss, which may result in a higher current tax burden. For that reason, the method generally isn't recommended for those trying to reduce their current year taxable income. In addition, this method doesn't specifically avoid short-term capital gains sales, which could result in a higher tax rate if a gain is realized.
High-cost lot method
Using the high-cost lot method, shares with the highest cost basis are sold first.
Method implications: The high-cost lot method results in the lowest capital gains or the greatest amount of realized losses for a sale. This method may be an appropriate if you want to reduce your taxable capital gains or are interested in tax-loss harvesting. However, this method could result in a higher tax rate if a gain is realized because it doesn’t specifically avoid short-term capital gains.
Method implications: The high-cost lot method results in the lowest capital gains or the greatest amount of realized losses for a sale. This method may be an appropriate if you want to reduce your taxable capital gains or are interested in tax-loss harvesting. However, this method could result in a higher tax rate if a gain is realized because it doesn’t specifically avoid short-term capital gains.
Method implications: The high-cost lot method results in the lowest capital gains or the greatest amount of realized losses for a sale. This method may be an appropriate if you want to reduce your taxable capital gains or are interested in tax-loss harvesting. However, this method could result in a higher tax rate if a gain is realized because it doesn’t specifically avoid short-term capital gains.
" id="body_disclosure--media_disclosure--175201" >Method implications: The high-cost lot method results in the lowest capital gains or the greatest amount of realized losses for a sale. This method may be an appropriate if you want to reduce your taxable capital gains or are interested in tax-loss harvesting. However, this method could result in a higher tax rate if a gain is realized because it doesn’t specifically avoid short-term capital gains.
Tax Lot Optimizer™
The Tax Lot Optimizer uses an algorithm to calculate the optimal way to minimize the tax impact of each sale. In general, the goal is to sell investments for losses first (short-term losses, then long-term losses) and gains last (long-term gains, then short-term gains).
Method implications: Like the high-cost lot method, the Tax Lot Optimizer looks for the highest cost shares first, and the algorithm also considers the holding period of each share. This method can be a good option for investors seeking to minimize taxes or looking to tax-loss harvest. But be aware, although this method tries to avoid short-term capital gains, that's not always possible if shares have been held less than one year.
Method implications: Like the high-cost lot method, the Tax Lot Optimizer looks for the highest cost shares first, and the algorithm also considers the holding period of each share. This method can be a good option for investors seeking to minimize taxes or looking to tax-loss harvest. But be aware, although this method tries to avoid short-term capital gains, that's not always possible if shares have been held less than one year.
Method implications: Like the high-cost lot method, the Tax Lot Optimizer looks for the highest cost shares first, and the algorithm also considers the holding period of each share. This method can be a good option for investors seeking to minimize taxes or looking to tax-loss harvest. But be aware, although this method tries to avoid short-term capital gains, that's not always possible if shares have been held less than one year.
" id="body_disclosure--media_disclosure--175241" >Method implications: Like the high-cost lot method, the Tax Lot Optimizer looks for the highest cost shares first, and the algorithm also considers the holding period of each share. This method can be a good option for investors seeking to minimize taxes or looking to tax-loss harvest. But be aware, although this method tries to avoid short-term capital gains, that's not always possible if shares have been held less than one year.
Specified lot method (a.k.a. specific identification)
When placing a sell order, you can identify which specific lots of shares to sell. Unfortunately, this specified lot method can't be set as your account default because it can't be automated; it requires you to manually select each share you want to sell. The advantage is the method is that it allows the greatest control over the realization of gains and losses.
Method implications: The specified lot method can be used to target the exact shares to sell, offering the most flexibility and control over your taxes. Using this method allows you to avoid realizing short-term capital gains, wash sales when tax-loss harvesting, or specifically target a certain amount of capital gains to fill up a tax bracket. But that control comes at a cost: It requires the most effort to implement, and if you use a tax advisor, this method could have an additional cost associated with that advice.
Method implications: The specified lot method can be used to target the exact shares to sell, offering the most flexibility and control over your taxes. Using this method allows you to avoid realizing short-term capital gains, wash sales when tax-loss harvesting, or specifically target a certain amount of capital gains to fill up a tax bracket. But that control comes at a cost: It requires the most effort to implement, and if you use a tax advisor, this method could have an additional cost associated with that advice.
Method implications: The specified lot method can be used to target the exact shares to sell, offering the most flexibility and control over your taxes. Using this method allows you to avoid realizing short-term capital gains, wash sales when tax-loss harvesting, or specifically target a certain amount of capital gains to fill up a tax bracket. But that control comes at a cost: It requires the most effort to implement, and if you use a tax advisor, this method could have an additional cost associated with that advice.
" id="body_disclosure--media_disclosure--175246" >Method implications: The specified lot method can be used to target the exact shares to sell, offering the most flexibility and control over your taxes. Using this method allows you to avoid realizing short-term capital gains, wash sales when tax-loss harvesting, or specifically target a certain amount of capital gains to fill up a tax bracket. But that control comes at a cost: It requires the most effort to implement, and if you use a tax advisor, this method could have an additional cost associated with that advice.
Using cost basis methods to lower taxes
Say you bought 500 shares of the XYZ fund 10 years ago for $10 per share for a total cost of $5,000 (for the sake of simplicity, we'll ignore commissions on all the trades). Five years later, you bought a second block of 500 shares for $60 per share ($30,000 total). Finally, 10 months ago, you bought 200 shares for $65 each ($13,000 total).
Today, the fund's share price is trading at $100, and you decide to sell 100 shares. You're currently in the 15% long-term capital gain tax bracket and 24% short-term capital gain tax bracket. You want to minimize the taxes on this transaction, so which cost basis method should you choose?
In this example, the Tax lot Optimizer and specified lot methods produced the lowest taxes due of $600 (in green) compared to the least tax-efficient methods of FIFO and low-cost with taxes of $1,350 (in red). Notice how the smallest capital gains were realized using the LIFO and high-cost methods ($3,500); however, the taxes were not the lowest at $840. This is because the methods are realizing short-term capital gains, which are taxed at a higher rate.
But remember, this is just an example. To determine the best methods for your particular situation, consider meeting with a financial or tax advisor.
Cost basis method
- Cost basis of shares sold
- Taxable capital gain
- Tax on gain
-
Average
>
Cost basis of shares sold
$4,000 (100 shares x $40)
>
Taxable capital gain
$6,000 ($10,000 – $4,000)
>
Tax on gain
$900 ($6,000 x 15%)
>
-
FIFO
>
Cost basis of shares sold
$1,000 (100 shares x $10)
>
Taxable capital gain
$9,000 ($10,000 – $1,000)
>
Tax on gain
$1,350 ($9,000 x 15%)
>
-
LIFO
>
Cost basis of shares sold
$6,500 (100 shares x $65)
>
Taxable capital gain
$3,500 ($10,000 – $6,500)
>
Tax on gain
$840 ($3,500 x 24%)
>
-
Low cost
>
Cost basis of shares sold
$1,000 (100 shares x $10)
>
Taxable capital gain
$9,000 ($10,000 – $1,000)
>
Tax on gain
$1,350 ($9,000 x 15%)
>
-
High cost
>
Cost basis of shares sold
$6,500 (100 shares x $65)
>
Taxable capital gain
$3,500 ($10,000 – $6,500)
>
Tax on gain
$840 ($3,500 x 24%)
>
-
Tax Lot Optimizer
>
Cost basis of shares sold
$6,000 (100 shares x $60)
>
Taxable capital gain
$4,000 ($10,000 – $6,000)
>
Tax on gain
$600 ($4,000 x 15%)
>
-
Specified lot
>
Cost basis of shares sold
$6,000 (100 shares x $60)
>
Taxable capital gain
$4,000 ($10,000 – $6,000)
>
Tax on gain
$600 ($4,000 x 15%)
>
- Source
Schwab Center for Financial Research. The example is hypothetical and provided for illustrative purposes only.
Identifying shares and setting your default cost basis method
How do you identify the specific shares you want to sell?
If you're placing the order by phone, tell your broker which shares you want to sell (for example, "the shares I bought on July 5, 2012, for $11 each").
At Schwab, if you place the order online, you'll see your cost basis method on the order entry screen. If you select the specified lot method, you'll be able to specifically identify which shares you want to sell.
To change your default cost basis method, log in to your Schwab.com account and select your account icon in the upper right corner and select Account Settings. This brings up a page where you can change your cost basis method for each of your accounts.
Reporting rules for cost basis
Brokerage firms are only required to report your cost basis to the IRS when you sell an investment purchased after one of the following dates:
- Equities (stocks, including real estate investment trusts, or REITs) acquired on or after January 1, 2011
- Mutual funds, ETFs, and dividend-reinvestment plans acquired on or after January 1, 2012
- Other specified securities, including most fixed income securities (generally bonds) and options acquired on or after January 1, 2014
Whether or not a brokerage reports your cost basis to the IRS, you're still responsible for reporting the correct amount when you file your taxes.
Brokerage firms are only required to report your cost basis to the IRS when you sell an investment purchased after one of the following dates:
- Equities (stocks, including real estate investment trusts, or REITs) acquired on or after January 1, 2011
- Mutual funds, ETFs, and dividend-reinvestment plans acquired on or after January 1, 2012
- Other specified securities, including most fixed income securities (generally bonds) and options acquired on or after January 1, 2014
Whether or not a brokerage reports your cost basis to the IRS, you're still responsible for reporting the correct amount when you file your taxes.
Brokerage firms are only required to report your cost basis to the IRS when you sell an investment purchased after one of the following dates:
- Equities (stocks, including real estate investment trusts, or REITs) acquired on or after January 1, 2011
- Mutual funds, ETFs, and dividend-reinvestment plans acquired on or after January 1, 2012
- Other specified securities, including most fixed income securities (generally bonds) and options acquired on or after January 1, 2014
Whether or not a brokerage reports your cost basis to the IRS, you're still responsible for reporting the correct amount when you file your taxes.
So, which method should you choose?
Because each investment you purchase could have a different cost basis and holding period, no single automated cost basis method will work perfectly in every situation. Each method has its benefits and downsides, depending on what you're trying to accomplish.
Generally, we suggest investors specifically identify the shares they want to sell on every trade, because this offers the most control over the gain or loss realized. The specified lot method offers the potential to maximize tax efficiency—especially if you use other tax-smart strategies, such as tax-loss harvesting, tax-gain harvesting, or donating appreciated assets to your favorite charity.
If you're looking for a cost basis method that is automated, and you also want to minimize taxes, we generally suggest using the Tax Lot Optimizer. This method can offer a high level of tax efficiency but with less effort of selecting each individual share to sell.
Whichever method you decide to use, it's important to plan ahead, so you aren't stuck with a huge tax bill come tax season. To truly maximize the tax benefits of each method, its best to work with a tax professional and/or wealth manager who can help you implement a holistic tax and financial plan.
Learn how to calculate cost basis.
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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.
Investing involves risks, including loss of principal.
The information and content provided herein is general in nature and is for informational purposes only. It is not intended, and should not be construed, as a specific recommendation, individualized tax, legal, or investment advice. Tax laws are subject to change, either prospectively or retroactively. Where specific advice is necessary or appropriate, individuals should contact their own professional tax and investment advisors or other professionals (CPA, Financial Planner, Investment Manager) to help answer questions about specific situations or needs prior to taking any action based upon this information.
Neither the tax-loss harvesting strategy, nor any discussion herein, is intended as tax advice and does not represent that any particular tax consequences will be obtained. Tax-loss harvesting involves certain risks including unintended tax implications. Investors should consult with their tax advisors and refer to the Internal Revenue Service (IRS) website at www.irs.gov about the consequences of tax-loss harvesting.
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