How do you track the cost basis
on investments held in your taxable portfolio?
What portfolio accounting method does your broker, custodian or advisor
report to you or your CPA? This is a
decision that, for some investors, can save thousands of dollars in taxes and
ultimately make a significant difference in the after-tax rate of return of
your portfolio.
Managing the tax impact when
selling an investment in your taxable portfolio is a critical component of a
tax-efficient investment strategy – especially with those investments whereby
dividends are reinvested or there are a series of purchases (i.e. dollar cost
averaging). The following are descriptions
of the portfolio accounting methods available to investors:
Average Cost
Method
As its name implies, the average cost
method keeps a running tally of the average cost of mutual fund or stock shares
that are purchased or sold over time, including reinvested dividends. The average cost accounting method is the
most commonly used method by mutual fund companies.
First in First
Out (FIFO)
The FIFO method assumes that the shares
sold were the first shares purchased.
This method realizes the maximum capital gains when an investment has
appreciated throughout its holding period.
The FIFO method is the "default” method for many brokerage firms.
Select Lot (or
Specific
Lot) Identification
The Select Lot method allows an investor
to identify the shares that are sold.
This is the most flexible portfolio accounting method and allows the
investor to have maximum control of any gains or losses generated when selling
an investment.
Last in First
Out (LIFO)
The LIFO method assumes that the shares
sold were the last shares that were purchased.
This method can result in higher short-term capital gains or
losses. Short-term capital gains are
generally taxed at higher tax rates than long-term capital gains.
High Cost
The High Cost
method assumes that those shares sold are the highest cost shares. This portfolio accounting method can result
in minimizing capital gains or maximizing capital losses.
The IRS is indifferent as to the accounting method that investors
utilize. However, the IRS has indicated
that investors should maintain consistency in whatever accounting method is
chosen. In other words, investors
choosing the average cost method cannot subsequently decide to convert to the
LIFO portfolio accounting method.
About Beacon Financial Strategies
Beacon Financial Strategies
is an independent financial planning, tax and investment advisory
firm located in Raleigh, NC. Beacon works with clients on a
consultative and objective basis to help them achieve their personal financial
goals. Beacon professionals specialize in the following areas of financial
planning: retirement feasibility planning, estate planning and coordination,
tax minimization strategies, and wealth management services.
Beacon Financial
Strategies provides both one-time and ongoing financial
planning, tax and investment advice to clients and operates in a fee-only,
fiduciary capacity.