what is the average cost basis method 
the average cost basis method is a system of calculating the value of mutual fund positions held in a taxable account to determine the profit or loss for tax reporting cost basis represents the initial value of a security or mutual fund that an investor owns the average cost is then compared with the price at which the fund shares were sold to determine the gains or losses for tax reporting the average cost basis is one of many methods that the internal revenue service irs allows investors to use to arrive at the cost of their mutual fund holdings zoe hansen investopediaunderstanding the average cost basis methodthe average cost basis method is commonly used by investors for mutual fund tax reporting a cost basis method is reported with the brokerage firm where the assets are held the average cost is calculated by dividing the total amount in dollars invested in a mutual fund position by the number of shares owned for example an investor who has 10 000 in an investment and owns 500 shares would have an average cost basis of 20 10 000 500 types of cost basis methodsalthough many brokerage firms default to the average cost basis method for mutual funds there are other methods available the first in first out fifo method means that when shares are sold you must sell the first ones that you acquired first when calculating gains and losses for example let s say an investor owned 50 shares and purchased 20 in january while purchasing 30 shares in april if the investor sold 30 shares the 20 in january must be used and the remaining 10 shares sold would come from the second lot purchased in april since both the january and april purchases would have been executed at different prices the tax gain or loss would be impacted by the initial purchase prices in each period also if an investor has had an investment for more than one year it would be considered a long term investment the irs applies a lower capital gains tax to long term investments vs short term investments which are securities or funds acquired in less than one year as a result the fifo method would result in lower taxes paid if the investor had sold positions that were more than a year old the last in first out lifo method is when an investor can sell the most recent shares acquired first followed by the previously acquired shares the lifo method works best if an investor wants to hold onto the initial shares purchased which might be at a lower price relative to the current market price the high cost method allows investors to sell the shares that have the highest initial purchase price in other words the shares that were the most expensive to buy get sold first a high cost method is designed to provide investors with the lowest capital gains tax owed for example an investor might have a large gain from an investment but doesn t yet want to realize that gain but needs money having a higher cost means that the difference between the initial price and the market price when sold will result in the smallest gain investors might also use the high cost method if they want to take a capital loss from a tax standpoint to offset other gains or income conversely the low cost method allows investors to sell the lowest priced shares first in other words the cheapest shares you purchased get sold first the low cost method might be chosen if an investor wants to realize a capital gain on an investment once a cost basis method has been chosen for a specific mutual fund it must remain in effect brokerage firms will provide investors with appropriate annual tax documentation on mutual fund sales based on their cost basis method elections investors should consult a tax advisor or financial planner if they are uncertain about the cost basis method that will minimize their tax bill for substantial mutual fund holdings in taxable accounts the average cost basis method may not always be the optimal method from a taxation point of view please 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 the specific identification method also known as specific share identification allows the investor to choose which shares are sold in order to optimize the tax treatment for example let s say an investor purchases 20 shares in january and 20 shares in february if the investor later sells 10 shares they can choose to sell five shares from the january lot and five shares from the february lot example of cost basis comparisonscost basis comparisons can be an important consideration let s say that an investor made the following consecutive fund purchases in a taxable account the total amount invested equals 52 000 and the average cost basis is calculated by dividing 52 000 by 3 500 shares the average cost is 14 86 per share suppose the investor then sells 1 000 shares of the fund at 25 per share the investor would have a capital gain of 10 140 using the average cost basis method the gain or loss using average cost basis would be as follows results can vary depending on the cost basis method chosen for tax purposes from strictly a tax standpoint the investor would be better off selecting the fifo method or the high cost method to calculate the cost basis before selling the shares these methods would result in no tax on the loss however with the average cost basis method the investor must pay a capital gains tax on the 10 140 in earnings of course if the investor sold the 1 000 shares using the fifo method there s no guarantee that 25 will be the selling price when the remaining shares are sold the stock price could decrease wiping out most of the capital gains and an opportunity to realize a capital gain as a result investors must weigh whether to take the gain today and pay the capital gains taxes or try to reduce their taxes and risk losing any unrealized gains on their remaining investment 