Using Average Cost Or FIFO?

Sunday, September 14, 2014 23:23
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Using Average Cost Or FIFO?

Tags: average cost | cost basis | FIFO | high cost | tax lots | Tax-efficient investing

I am amazed when I run across advisors who are still using average cost or FIFO for tax lot accounting. Do they not realize that their clients are paying more taxes than necessary each year? In these days of automation and "check the box" custodian options, it borders on malpractice to not minimize clients' tax bills. 

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I'm sure some of the "guilty" justify their actions (or non-action) because selling higher cost lots merely postpones tax. I don't buy it. Clients would rather pay tax later than sooner. Also, unless the client is going to sell everything prior to death, some of the temporary tax savings will become permanent. 
 
The cost basis rules allow changing methods - going forward. Even though basis methods can't be changed for old shares, advisors can ensure that their clients don't pay extra tax on sales of new shares. 
 
If the advisor is willing to do some work to specifically identify lots or use a program like Total Rebalance Expert, the optimal method is as follows (in order):
 
1) Sell highest cost loss positions. 
2) Sell break-even lots. 
3) Sell highest cost long term gains
4) Sell highest cost short term gains. 
 
(Since net short-term and long-term losses offset net short-term and long-term gains, I believe that it is better to recognize a larger long-term loss than a smaller short-term loss.)
 
Advisors wanting to take advantage of a custodian's preset option should use either "high cost" or "best tax." High cost will differ from the above recommendation by recognizing the highest cost gains, whether short or long term. Thus, the recommended method would recognize a $1,000 long-term gain before a $500 short-term gain. Under high cost, the $500 short-term gain would be recognized first. 
 
The "best tax" method is similar to the recommended method except it will recognize short-term losses before long-term losses. Thus, the recommended method would recognize a $1,000 long-term loss before a $500 short-term loss. Under "best tax", the $500 short-term loss would be recognized first. 
 
Although I believe that the recommended method is best, advisors who want to give their clients better tax consequences without extra work should choose the custodian's "high cost" or "best tax" options. 
 

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