Adjusted average cost: Meaning, Criticisms & Real-World Uses

What Is Adjusted Average Cost?

Adjusted average cost is a method used in Investment Taxation to determine the cost basis of an investment, primarily for shares of mutual funds and certain exchange-traded funds (ETFs) held in taxable accounts. This method calculates the average price paid for all shares of a specific security, incorporating all purchases, reinvested dividends, and capital gains distributions. When an investor sells a portion of their holdings, the adjusted average cost per share is used to calculate the capital gains or losses for tax reporting purposes. This approach simplifies record-keeping for investors who make frequent purchases or reinvest distributions.

History and Origin

The concept of cost basis accounting became increasingly relevant with the growth of the modern financial markets and the introduction of income taxes on investment gains. While the taxation of capital gains in the United States dates back to 1913, initially taxing them at ordinary rates, the rules for calculating the cost of assets for tax purposes have evolved significantly over time.¹⁸,¹⁷ Prior to broad regulatory requirements, investors often had discretion in choosing how to track the cost of their shares.

The average cost method gained prominence as a practical solution, particularly for pooled investments like mutual funds, where tracking individual share lots could be cumbersome. A significant regulatory change occurred in the U.S. when the IRS introduced new cost basis reporting requirements for "covered securities" purchased on or after January 1, 2012, requiring financial institutions to report cost basis information to both investors and the IRS on Form 1099-B.¹⁶,¹⁵,¹⁴ This legislation solidified the role of various cost basis methods, including the average cost method, which many mutual fund companies adopted as their default.¹³,¹²

Key Takeaways

Adjusted average cost simplifies the calculation of an investment's cost basis, especially for mutual funds.
It averages the total cost of all shares purchased, including reinvested distributions.
This method is primarily used for tax reporting purposes to determine capital gains or losses upon sale.
Investors must generally elect the average cost method in writing with their financial institution, and once elected for a fund, it typically must be used for all shares of that fund.
While simple, it may not always result in the lowest possible tax liability compared to other cost basis methods.

Formula and Calculation

The formula for calculating the adjusted average cost per share is straightforward:

\text{Adjusted Average Cost Per Share} = \frac{\text{Total Cost of All Shares Owned}}{\text{Total Number of Shares Owned}}

To determine the Total Cost of All Shares Owned, sum the original purchase price of all acquisitions, including any commissions or fees, and add the cost of shares acquired through the reinvestment of dividends and capital gains distributions.

For example, if an investor makes multiple purchases and reinvests distributions, the total cost would be the sum of these transaction amounts, and the total number of shares would be the sum of all shares acquired.

When shares are sold, the gain or loss is calculated as:

\text{Capital Gain/Loss} = \text{Sale Price} - (\text{Number of Shares Sold} \times \text{Adjusted Average Cost Per Share})

Interpreting the Adjusted Average Cost

Interpreting the adjusted average cost involves understanding its role in determining the taxable gain or loss from selling investment shares. This cost per share represents the average investment an individual has in each share of a given security. When an investor sells shares, any amount received above this adjusted average cost per share is considered a capital gain, while any amount below it is a capital loss.

The resulting gain or loss is then subject to capital gains tax rates, which depend on the holding period—whether the investment was held for a short-term (one year or less) or long-term (more than one year). A higher adjusted average cost reduces the potential capital gains and, consequently, the tax liability upon sale, or increases a capital loss that can be used to offset other gains.

Hypothetical Example

Consider an investor, Alex, who buys shares in a mutual fund.

January 1: Alex buys 100 shares at $10.00 per share, for a total of $1,000.
March 15: Alex buys an additional 50 shares at $12.00 per share, for a total of $600.
June 30: The fund distributes a capital gain, and Alex reinvests the distribution to acquire 10 shares at $11.50 per share, for a total of $115.

To calculate the adjusted average cost for Alex's investment portfolio:

Total Cost: $1,000 (initial purchase) + $600 (second purchase) + $115 (reinvested capital gains distributions) = $1,715
Total Shares: 100 shares + 50 shares + 10 shares = 160 shares

Adjusted Average Cost Per Share: $1,715 / 160 shares = $10.71875 per share.

Now, suppose Alex decides to sell 80 shares on September 1 when the share price is $13.00.

Sale Proceeds: 80 shares * $13.00/share = $1,040
Cost of Shares Sold (using Adjusted Average Cost): 80 shares * $10.71875/share = $857.50
Capital Gain: $1,040 - $857.50 = $182.50

Alex would report a capital gain of $182.50 for tax purposes, calculated using the adjusted average cost.

Practical Applications

Adjusted average cost is primarily used by individual investors for tax reporting on their non-retirement brokerage account holdings, especially for mutual funds. Its simplicity makes it a popular choice for those who engage in regular contributions or dividend reinvestment plans, as it removes the complexity of tracking specific share lots. This method can also be a component of broader financial planning strategies, particularly for investors focused on straightforward tax compliance rather than aggressive tax optimization.

While the method itself is simple, choosing it has long-term implications for an investor's tax liability. According to the IRS, brokerage firms are required to report cost basis information for "covered securities" purchased after specific dates, with many defaulting to the average cost method for mutual funds if no other method is chosen by the investor., ¹¹I¹⁰nvestors often consult with tax professionals to decide if the average cost method aligns with their overall financial goals and tax situation. Information regarding cost basis accounting and regulations can be found in IRS Publication 550, "Investment Income and Expenses (Including Capital Gains and Losses)."

⁹## Limitations and Criticisms

While convenient, the adjusted average cost method has limitations, especially concerning tax efficiency. One main criticism is that it may not always produce the most favorable tax outcome for investors., ⁸U⁷nlike methods that allow investors to select specific share lots, the average cost method does not permit strategic selling to minimize short-term capital gains or maximize long-term capital gains or losses.

For instance, if an investor has purchased shares at varying prices, some with substantial unrealized losses and others with significant gains, the average cost method dictates that all shares have the same average cost. This prevents investors from strategically selling high-cost shares to realize losses for tax-loss harvesting purposes, or selling long-term gain shares to take advantage of lower tax rates, while holding onto higher-cost shares. The average cost method typically results in an "average" tax outcome, which might be suboptimal for investors actively seeking to manage their tax liabilities. F⁶urthermore, once elected for a specific mutual fund, the method generally cannot be changed without IRS permission, making it a potentially restrictive choice.

⁵## Adjusted Average Cost vs. First-in, First-out (FIFO)

The adjusted average cost method and the First-in, First-out (FIFO) method are two common ways to calculate the cost basis of investment shares for tax purposes. The primary difference lies in how they determine which shares are considered sold.

Feature	Adjusted Average Cost	First-in, First-out (FIFO)
Calculation	Averages the cost of all shares purchased over time.	Assumes the first shares acquired are the first ones sold.
Applicability	Primarily used for mutual funds and certain ETFs.	Can be used for most types of securities (stocks, bonds, mutual funds).
Tax Impact	Tends to yield an "average" capital gain or loss; less flexible for tax optimization.	Can result in higher capital gains if older, lower-cost shares are sold first, but allows for more precise tax management if combined with specific identification.
Complexity	Simpler for record-keeping, especially with frequent transactions.	Requires tracking individual purchase lots and their respective costs and dates.
Default Method	Often the default for mutual funds at many brokerage firms., ⁴	³ Often the default for individual stocks and sometimes for mutual funds if no other method is chosen., ²

Confusion can arise because both methods are used for cost basis reporting, but they can produce significantly different capital gains or losses, and thus different tax liabilities, especially when share prices have fluctuated widely over the holding period.

FAQs

What is the primary purpose of calculating adjusted average cost?

The primary purpose of calculating adjusted average cost is to determine the cost basis of investment shares for tax reporting. This calculation helps ascertain the taxable gain or loss when those shares are sold, which is then reported to the Internal Revenue Service (IRS).

Is adjusted average cost mandatory for all investments?

No, adjusted average cost is not mandatory for all investments. It is primarily an option for mutual funds and some exchange-traded funds (ETFs) held in taxable accounts. Other common cost basis methods include First-in, First-out (FIFO), Last-in, First-out (LIFO), and Specific Identification, which can be used for different types of securities or in different circumstances.

Can I switch my cost basis method after choosing adjusted average cost?

Generally, once you elect the adjusted average cost method for a specific mutual fund, you must use that method for all subsequent sales of that fund unless you receive permission from the Internal Revenue Service to change it. This rule is in place to prevent investors from switching methods solely to gain a tax advantage.

Does reinvesting dividends affect the adjusted average cost?

Yes, reinvesting dividends significantly affects the adjusted average cost. Each time dividends are reinvested, new shares are purchased, adding to both the total number of shares and the total cost. This increases your overall cost basis and lowers the average cost per share, as you are essentially buying more shares at various prices.