How do capital gains work with continual investment?
August 13, 2016 5:56 PM Subscribe
Let's say I make a $1,000 investment into a mutual fund on Jan 1, 2016. On the 1st of every subsequent month through Dec 1, 2016, I contribute an additional $1,000. By end of year, my total purchase price is now $12,000. In the middle of January 2017, Let's say the market value of the fund is now $15,000 and I want to sell. Can someone help explain how capital gains tax would work in this scenario for the $3,000 gain? Some specific questions below the fold.
(Assume United States, non-retirement account):
1) Since the overall investment timeframe is > 1 year, do you avoid short term capital gains? Or is this really 12 distinct holding periods, each a year from the monthly purchase date?
2) If it's the latter, how does one know how much each incremental investment influenced the overall market gain?
3) If an investor wants to sell just a portion of the overall investment, how does the system work to ensure that the EARLIEST shares purchased are the ones sold first?
4) Do any of the answers above change if we are talking about individual stocks instead of mutual funds?
(Assume United States, non-retirement account):
1) Since the overall investment timeframe is > 1 year, do you avoid short term capital gains? Or is this really 12 distinct holding periods, each a year from the monthly purchase date?
2) If it's the latter, how does one know how much each incremental investment influenced the overall market gain?
3) If an investor wants to sell just a portion of the overall investment, how does the system work to ensure that the EARLIEST shares purchased are the ones sold first?
4) Do any of the answers above change if we are talking about individual stocks instead of mutual funds?
Best answer: There are a lot more options than LIFO and FIFO!
If you keep track of each lot separately, you can know the gain of each individual lot. Most brokerages (Vanguard or Fidelity or ETRADE or whatever) let you select a "cost basis method" that they use to determine your cost basis (i.e. how much you paid for the investment).
If you use specific identification of lots, you can look and see how much you paid for each lot, how much that specific lot is worth now, and what the unrealized gains/losses are on each lot.
I invest similar to the way you're talking about, and because I've requested specific identification of lots, I can look and see how much I've gained on every lot I've bought. This is handy if you want to cash out part (but not all) of the investment, because you can sell the lots that have appreciated the least and (temporarily) lower your tax bill.
Another common way of keeping track is FIFO - first in, first out. The first lot bought is the first lot sold. This can be inefficient for tax purposes, though, because the oldest shares are likely to have appreciated the most.
The third way my brokerage (Vanguard) offers, is Average Cost, which is easier than specific identification, but generally going to be more tax-efficient than FIFO - sort of in the middle.
You can do the calculation yourself, though, regardless of how the brokerage tracks it - you should be able to see how many shares of the mutual fund your $1000 paid for each month, and then you can calculate how much those shares are worth now. Easier to let the brokerage keep track though.
posted by mskyle at 6:13 PM on August 13, 2016
If you keep track of each lot separately, you can know the gain of each individual lot. Most brokerages (Vanguard or Fidelity or ETRADE or whatever) let you select a "cost basis method" that they use to determine your cost basis (i.e. how much you paid for the investment).
If you use specific identification of lots, you can look and see how much you paid for each lot, how much that specific lot is worth now, and what the unrealized gains/losses are on each lot.
I invest similar to the way you're talking about, and because I've requested specific identification of lots, I can look and see how much I've gained on every lot I've bought. This is handy if you want to cash out part (but not all) of the investment, because you can sell the lots that have appreciated the least and (temporarily) lower your tax bill.
Another common way of keeping track is FIFO - first in, first out. The first lot bought is the first lot sold. This can be inefficient for tax purposes, though, because the oldest shares are likely to have appreciated the most.
The third way my brokerage (Vanguard) offers, is Average Cost, which is easier than specific identification, but generally going to be more tax-efficient than FIFO - sort of in the middle.
You can do the calculation yourself, though, regardless of how the brokerage tracks it - you should be able to see how many shares of the mutual fund your $1000 paid for each month, and then you can calculate how much those shares are worth now. Easier to let the brokerage keep track though.
posted by mskyle at 6:13 PM on August 13, 2016
Best answer: There are two ways to account for, or track, your cost basis: average cost, or by individual lots. The default sales order is first-in, first-out.
If you used average cost basis, then I believe selling all of them would qualify as long term gains. If you used specific lots, then only the first one qualifies for long term.
Bogleheads has a good wiki on these topics.
posted by Dashy at 6:15 PM on August 13, 2016 [1 favorite]
If you used average cost basis, then I believe selling all of them would qualify as long term gains. If you used specific lots, then only the first one qualifies for long term.
Bogleheads has a good wiki on these topics.
posted by Dashy at 6:15 PM on August 13, 2016 [1 favorite]
Best answer: You calculate the total amount that you put in - that is your cost. Subtract from the selling price, that is your gain. Technically each purchase is a separate transaction. On a practical level, you can combine all of the long term gain and report them on one line of your tax form (assuming US taxes) and then combine all of the short term gains and report them on one line.
To allocate how much the gain is for each transactions, you need to know the number of shares (not the just the dollar value). Divide the sale price by the number of shares sold, match that the cost of each set of particular shares and then you know the gain for each transaction.
If you only sell part, you can designate by date of purchase which shares you are selling.
The rules are same for individual stock and mutual funds. If these are mutual fund shares, the company will be tracking all this and report it to you (I think they default to the assumption of first in/first out) but they don't report the gain to the IRS since you might calculate it differently. BUT, if you do then you need to keep track carefully until you sell everything so you know which specific shares you still hold and which were already sold.
Also, if these are mutual funds, if you are reinvesting dividends, each reinvestment is a separate purchase which adds to your cost basis and needs to be added into your calculations. This reduces your taxes but adds to the paperwork.
posted by metahawk at 6:16 PM on August 13, 2016 [1 favorite]
To allocate how much the gain is for each transactions, you need to know the number of shares (not the just the dollar value). Divide the sale price by the number of shares sold, match that the cost of each set of particular shares and then you know the gain for each transaction.
If you only sell part, you can designate by date of purchase which shares you are selling.
The rules are same for individual stock and mutual funds. If these are mutual fund shares, the company will be tracking all this and report it to you (I think they default to the assumption of first in/first out) but they don't report the gain to the IRS since you might calculate it differently. BUT, if you do then you need to keep track carefully until you sell everything so you know which specific shares you still hold and which were already sold.
Also, if these are mutual funds, if you are reinvesting dividends, each reinvestment is a separate purchase which adds to your cost basis and needs to be added into your calculations. This reduces your taxes but adds to the paperwork.
posted by metahawk at 6:16 PM on August 13, 2016 [1 favorite]
Response by poster: This is great insight... thanks! I now have a better grasp of the right terms to use to Google this further. A few quick followup questions: I know that every situation is unique, but is there a specific cost basis strategy that is generally advantageous in MOST circumstances (i.e. average cost or HIFO)? If not, are there any useful calculators or tools to help an investor determine which to use? Is this something a tax accountant is generally able to solve for you?
posted by jason and the garlic knots at 6:47 PM on August 13, 2016
posted by jason and the garlic knots at 6:47 PM on August 13, 2016
Best answer: Specific lots give you much finer control over what your gains will be for any sale. You can also do things like tax loss harvesting - selling specific lots that have a loss, in order to balance the gains from other sales, and pay no net taxes on that situation.
Average cost might be better if you have many transactions - for instance if you set up an automatic purchase every week - and possibly if you're a buy-and-hold-forever person (but given the question you asked, maybe you are not?).
You can switch between them (but read the link I posted above).
posted by Dashy at 7:02 PM on August 13, 2016
Average cost might be better if you have many transactions - for instance if you set up an automatic purchase every week - and possibly if you're a buy-and-hold-forever person (but given the question you asked, maybe you are not?).
You can switch between them (but read the link I posted above).
posted by Dashy at 7:02 PM on August 13, 2016
Best answer: If you are going to go to the trouble of identifying specific lots, then you usually want to sell that ones that produce the lowest tax burden (losses first then highest cost basis of your long term gains) - it doesn't avoid taxes but it allows you to postpone them.
On the other hand, with monthly purchases plus possible dividends reinvestment you need to seriously consider how much it worth to delay the tax payment for a few years versus time saved plus better accuracy of letting the investment company do it for you. Personally, I let them calculate the average cost basis for me for all our mutual funds and do it myself for individual stock but then my stock transactions are a couple of times a year for any given holding.
Also, if you are both buying and selling the same stock and end up with tax loss, be sure to read up about wash sales.
posted by metahawk at 11:23 PM on August 13, 2016
On the other hand, with monthly purchases plus possible dividends reinvestment you need to seriously consider how much it worth to delay the tax payment for a few years versus time saved plus better accuracy of letting the investment company do it for you. Personally, I let them calculate the average cost basis for me for all our mutual funds and do it myself for individual stock but then my stock transactions are a couple of times a year for any given holding.
Also, if you are both buying and selling the same stock and end up with tax loss, be sure to read up about wash sales.
posted by metahawk at 11:23 PM on August 13, 2016
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posted by Sweetie Darling at 6:12 PM on August 13, 2016