Learn More Tax-Wise Ways to Cash in Taxable Gains of Funds, Stocks

Savvy investors who sell less than the entire position of a stock or mutual fund in a taxable account have some control over the amount of capital gains taxes they pay. The strategies are particularly im- portant to retired investors who often sell a portion of their holdings each year to pay expenses. The capital gain or loss on the sale of an investment is determined by subtracting the cost of acquiring the asset (the basis in tax lingo) from the sale price (the amount realized).

If you’re selling all of your position in the account or acquired the position in one purchase, the tax reduction strategies are limited. Your basis is your total cost. When you’re selling less than the entire position in an investment, es- pecially when you acquired the shares over time, the tax law provides choices in the method for calculating the basis.

A different basis means a different gain or loss and a different tax bill. FIFO (first-in, first out) is the default method for calculating the basis for stocks if neither you nor your broker chooses another method. It probably is the easiest method, if you have all the details, but it also can result in the highest taxes because investment prices tend to increase over time. So, the basis of the shares pur- chased first is likely to be lower than the basis of shares purchased later.

The average cost method is the default method for computing the basis for mutual fund shares and can be used only for mutual funds or stocks acquired under dividend reinvestment plans. The method is exactly what the name says.

You add the cost of all the shares you own in a fund or stock and divide the sum by the total number of shares held. Average cost used to have a sin- gle-category and a double-category method, but the double-category meth- od was eliminated as of April 1, 2011. Specific identification also is exactly what the name says.

You decide which shares are sold. You might decide to sell the shares with the highest basis, so your taxable gain this year will be mini- mized, or the loss will be maximized. Or you could sell shares with the low- est basis. This might be beneficial when you have capital losses to offset the gains or will be in a lower tax bracket than usual because of deductions or reduced income.

You also could decide to sell shares with close to the average basis and reserve the highest and lowest basis shares for another year. The specific identification method also lets you decide whether to sell shares that were held for one year or less (resulting in short-term gains or losses) or those held for more than one year (resulting in tax-favored long- term capital gains). The specific identification method al- lows optimum tax management, but it requires good recordkeeping and some work.

You must track which shares you bought each year and their basis. Then, you need to adjust the records as shares are bought and sold. You must review the records and identify the shares sold before issuing the sell order. Some brokers automate the specific identification method for investors who make their trades online.

For example, on its website, Fidelity offers a number of methods, such as intraday FIFO; last in, first out; high cost; and low cost. To use the specific share method, you must contact the broker or mutual fund before selling the shares and identify the shares to be sold. The contact must be in writing, and most firms have a specified form or web page you must use. If you have any doubts, contact the broker to be sure of the details. Also, you need to receive written confirma- tion from the firm of the specific shares that were sold. Example. Suppose Max Profits purchased shares of the Vanguard 500 Index fund twice a year for 20 years and had distributions reinvested.

The share price fluctuated quite a bit, from about $90 to almost $450 in late 2021 and recently was about $415. Max now plans to sell some shares each year to fund retirement. Max could use the default average cost method to determine his basis, which probably is around $200. That would give him a capital gain or loss on each share sold equal to the current sale price minus $200. An alternative is to use FIFO and ini- tially sell the first shares purchased.

Af- ter those shares are sold, Max sells the next shares purchased and so on. The amount of taxable gains will fluctuate from year to year but will be substan- tial because the recent price is much higher than the shares Max purchased in the early years. The share price didn’t exceed $200 until 2015. Max wouldn’t have much control over the amount of taxes paid each year. Finally, Max can use the actual cost/ specific identification method.

That gives Max more control over his annual tax bill. If the market declines, for example, he might sell the highest-cost shares, so he has deductible losses or small gains. In some years, such as when he has losses from other invest- ments, he might sell the lowest-priced shares, so the other losses offset those gains. Brokers and mutual fund firms are required to report sales to the IRS and investors each year on Form 1099-B, and the reports must include the basis of securities sold. Many firms also re- port the basis in year-end statements to investors.

Basis must be reported only for stocks purchased after 2010 and mutual funds purchased after 2011. Remember, each broker and mutual fund firm establishes a default method for computing basis that is consistent with the IRS regulations. An investor is told the broker’s default method when the account is opened and has an opportunity to elect out of it. After an account is established, you can elect out of the default method but with some limits.

When shares in a mutual fund were sold and the basis was computed using the average cost method, you must use the average cost method for that fund until all the shares are sold. But you can elect out of the average cost method for any other fund in that account if you haven’t sold any shares in that fund. You can elect to use the average cost method for mutual funds at any time. If you already sold some shares of that fund and used another method, you can use the average cost method for future sales.

Under these rules, you can select dif- ferent cost basis methods for different securities and different accounts. Reducing the taxes on your invest- ment gains is the surest way to increase after-tax returns.

One way to do that is to manage the basis used to report the sales of stocks and mutual funds. You need to work with your fund firm or broker to determine the default basis method, your options for using a different method, and how to choose another method. You might also want to work with a tax advisor to select the best method to use. More details about the choices for computing the basis of investments sold are in free IRS Publication 550, Investment Income and Expenses, avail- able on the IRS website.