What is Cost Basis
Feb 23, 2023 By Rick Novak

Cost basis refers to an asset's original acquisition price. Your cost basis when purchasing mutual funds, stocks, or other securities is the amount you paid on the day of acquisition. Cost basis covers the assets purchase price and any mutual fund load fees, brokerage fees, and other trade-related expenses you incur.

For various reasons, you must know how to calculate the cost basis of mutual funds or other assets. As previously noted, you can assess your potential capital gain by looking at your cost basis when considering whether to sell appreciated equities.

According to IRS regulations, capital gains on the sale of stocks, mutual funds shares, or other investments are taxable. Investments kept for a shorter period than a year are subject to the short-term tax rate on capital gains. For investments kept for more than a year, you will be subject to a more favorable long-term tax rate on capital gains.

When working with mutual funds, the cost basis calculation can be complicated because dividends are frequently paid out, and capital gains payments are typically reinvested in the mutual fund.

Cost Basis Example

Let's suppose you currently have 100 shares of a mutual fund. At an average cost of $6 per share, your investment costs you $600. You should receive $40 since the mutual fund pays a $0.40 dividend per share. But you've already decided to put the dividends back into the fund. You can buy four more shares with the dividends at the fund's current price of $10. Now that you possess 104 shares, your cost basis is $6.15 ($640/104).

Methods for Calculating Cost Basis

The investor has a few alternatives when determining which cost basis method to employ to determine the gain or loss in the capital on selling shares of a mutual fund.

FIFO

The FIFO, or "First in, First Out" method, clearly states that the first shares bought are also the first shares traded first. As a result, every investment has its own cost basis in the mutual fund. The initial share you purchased at $6 in the above example would be the cost basis if you sold one share.

For investors hoping to gain long-term investing advantages, the FIFO system is more beneficial. Investments kept for more extended periods frequently enjoy more attractive tax regulations, such as reduced taxes on capital gains. Reduced tariffs are frequently paid when using the FIFO technique to sell shares bought more than a year ago rather than those purchased recently.

If your cost basis is more significant, you'll pay less in taxes. This is because the profit you make when selling an investment would be less than when buying it.

Alternatively, a low-cost basis may indicate that you made a profitable early investment. However, you'll have to pay higher taxes on capital gains because your investment profit is more prominent.

Average Cost Method

By dividing the investments made, including capital gains and dividends, by the number of shares owned, the average cost method determines the cost basis for the single category. Then, this average cost basis method is applied anytime you sell shares. The complete pool of assets must be divided into two categories: long-term and short-term investments, following the average cost basis for the double category. The average price for each distinct period is then determined.

Since the average cost strategy does not require a particular listing of the bought or sold shares, it's indeed simpler to calculate. However, taxpayers may have a reduced cost basis for some transactions due to aggregating the historical cost, resulting in more significant capital gains.

Equivalent capital gains values will be generated by each method and utilized to determine the tax obligation. Investors should therefore select the strategy that offers them the most tax benefit.

Calculation of Cost Basis for Mutual Funds

Investors can calculate the average cost basis for mutual funds using the FIFO method, which identifies the first shares acquired, or the average cost technique, which adds up share prices, is used to determine the cost basis for mutual funds. According to the average cost technique, you must keep records of the average cost of recent-purchased short-term stocks differently from long-term shares (kept for more than a year).

What is the Best Cost Basis Method For Mutual Funds

Potential capital gains will vary depending on the cost basis. If the mutual fund price has declined over time, you might get more tax profit from FIFO because your average cost basis for the initial shares you bought will be the highest.

Alternatively, if the mutual fund price has grown, your taxes on capital gains will be less according to the average cost method. Using this method, you can utilize greater shares acquired later and average your costs rather than having a lower cost basis when you initially invested in them.

Bottom Line

When buying or selling stocks, it is crucial to understand how to determine the cost basis of mutual funds is important for tax reporting. Your capacity to keep much more of your investment earnings depends on how much tax obligation you can reduce.