What is Average Cost Basis?
Average cost basis is defined as the means to attribute the purchase price to shares underlying a mutual fund or an account managed by a custodian (broker). It is calculated as the total amount paid to purchase the mutual fund or investment in a custodian account divided by the total number of underlying shares. The utility of the average cost basis method is its simplicity during multiple purchases, reinvestment of dividends, and actual capital gains.
Summary
- Cost basis is a tool for establishing the starting point or purchase point for the initiation of tax calculation provided a profit is generated. Profits are the returns generated and above the cost basis.
- Average cost basis is one of the methods available among several other methods to determine the cost basis.
- Average cost basis is widely used owing to its ease of use. The average cost price is the total purchase amount divided by the total number of shares.
Importance of Cost Basis
The cost basis forms the fulcrum around which the investor comes to know whether they’ve earned a profit or loss. Average cost basis is not the only method; there are other methods like LIFO, HIFO, and specific identification that are available. The average cost method is the easiest to administer and calculate. However, the average cost method may not always be the most tax-efficient.
Example 1: Mutual Fund Purchase
Let’s assume an investor buys the same mutual fund (units /shares) on two separate occasions, i.e., Feb. 1, 2019 and Mar. 2, 2019 for an outflow of $1,000 and $2,500, respectively.
After a month, a dividend worth of $100 is received, and the entire proceeds of the dividend are reinvested to purchase new units.
The average cost basis is defined as the total purchase amount divided by the total number of shares. It works out to $28.53.
Date | Transaction | Share Price | Purchase Amount | No. of Shares |
Feb. 1, 2019 | Buy | $25 | $1,000 | 40 |
Mar. 2, 2019 | Buy | $30 | $2,500 | 83.3 |
Mar. 4, 2019 | Reinvestment of Dividends | $35 | $100 | 2.9 |
Total | $3,600 | 126.2 | ||
Average Cost Basis | $28.53 |
The cost basis of $28.53 is the reference point around which gains and losses would now be calculated for taxation purposes.
Let us suppose after a couple of months the investor sells 40 shares for $50.
Date | Transaction | Share Price | Proceeds | No. of Shares |
May 2, 2019 | Sell | $50 | $2,000 | 40 |
Working on Average Cost Basis
Cost Basis of the 40 Shares | No. of Shares (40) * Average Cost Basis (28.53) = $1,412.20 |
Sales Proceeds | $2,000 |
Capital Gains from the Transaction | $2,000 – $1,412.20 = $858.80 |
From the investor’s marginal tax rate, we can now calculate the incidence of taxation (assume a tax rate of 30%) | Capital Gains ($858.80) * Tax Rate (30%) = $257.64 |
The importance of the cost basis stems from the fact that it is the price that is used to determine whether an investor makes a profit or loss. The presence of profits would lead to the incidence of taxation. The average cost basis should not be construed as a proxy for performance.
As illustrated above, the cost basis helps in establishing the starting point to calculate the profit or loss from a tax point of view. Losses are not taxed, whereas profits are taxed. However, not all profits are taxed equally. Short-term profits are taxed at a higher rate, whereas long-term profits are taxed at a lower rate. Average cost basis thus helps determine what is taxable and what is not taxable.
Example 2: Purchase of ETFs
An investor named Mr. X decides to secure exposure to a basket of securities using an exchange-traded fund (ETF). The cost basis of the purchase can be determined in several ways, especially in the United States. At the one end of the spectrum, there is the FIFO method, and at the other end, there is the average cost method.
Let us suppose Mr. X purchases 100 shares of Company QQQ at $10 each for a net outflow of $1,000 on Jan. 2, 2020. At the beginning of the next quarter, Apr. 3, Mr. X decides to purchase another 50 shares of QQQ at $7 each, totaling $350. Now, let us look at the cost basis under the two different methods.
Date | Transaction | Share Price | No. of Shares | Purchase Amount |
Jan. 2, 2020 | Buy | $10 | 100 | $1,000 |
Apr. 3, 2020 | Buy | $7 | 50 | $350 |
Date | Transaction | Share Price | No. of Shares | Average Cost | FIFO Cost |
Apr. 30, 2020 | Redemption | $12 | 50 | Total Purchase Amount/ Total Number of Shares | Purchase Price of First 50 Shares |
Calculation | $1,350 / 150 = $9 | $10 | |||
Profit Per Share | $12 – $9 = $3 | $12 – $10 = $2 | |||
Total Profit | 50 * $3 = $150 | 50 * $2 = $100 |
As illustrated above, we can clearly see that the average cost method is the least punitive method of calculating the cost basis. An investor can benefit from the FIFO method only when the initial tranche of shares are purchased at a lower price.
It may not be the case all the time, as can be seen from the example above. Hence, the average cost basis provides the best compromise between the lowering of cost basis and ease of calculation.
More Resources
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