Adjusted long term average cost

The Adjusted Long-Term Average Cost is a specific method used in Investment Accounting to determine the cost basis of certain investments, primarily mutual funds, held over an extended period. This method involves calculating a single average cost for all shares of a particular fund, regardless of when they were purchased or at what price. This average is then used to compute capital gains or capital losses when shares are sold from a taxable account.

History and Origin

The concept of average cost basis for mutual funds has long been recognized for its simplicity in managing complex investment records, especially given frequent purchases through dividend reinvestment plans and regular contributions. For tax purposes, the Internal Revenue Service (IRS) has permitted the use of the average cost method for mutual funds. The modern regulatory landscape for cost basis reporting, including the average cost method, was significantly shaped by the Energy Independence and Security Act of 2007, which introduced new requirements for brokers to report cost basis information to both the IRS and taxpayers. These regulations became effective for mutual funds and exchange-traded funds (ETFs) purchased on or after January 1, 2012.¹⁶, ¹⁷, ¹⁸ This change aimed to simplify tax implications and improve reporting accuracy for investors.

Key Takeaways

• The Adjusted Long-Term Average Cost method simplifies the calculation of gains and losses for tax reporting, particularly for mutual funds.
• It averages the cost of all shares held, rather than tracking individual purchase lots.
• This method is generally available for mutual funds, ETFs, and certain dividend reinvestment plans.¹⁵
• Once elected for a specific mutual fund, the method must be used for all shares of that fund across all accounts.¹⁴
• The IRS provides detailed guidance on this and other accounting methods in Publication 550.¹³

Formula and Calculation

The formula for the Adjusted Long-Term Average Cost (Average Basis) is straightforward:

Where:

• Total Cost of All Shares Held: This includes the original purchase price of all shares, plus any commissions or fees paid when buying the shares, and the cost of shares acquired through dividend reinvestment.¹²
• Total Number of Shares Held: The cumulative number of shares of the mutual fund owned.

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

This calculation helps determine the reported gain or loss for financial reporting purposes.

Interpreting the Adjusted Long-Term Average Cost

The Adjusted Long-Term Average Cost provides a single, smoothed-out cost per share for an investment, which can simplify portfolio tracking. For investors who make frequent, small investments, such as through regular contributions or automatic dividend reinvestments, this method can be less cumbersome than tracking each individual share lot. It means that regardless of market fluctuations at the time of purchase, all shares contribute to a unified average. However, this simplification also means that the specific purchase price of any particular share is not directly reflected when calculating gains or losses upon sale. It’s crucial for investors to understand that while brokerage firms may default to this method for mutual funds, they often have the option to choose a different cost basis method.

¹⁰, ¹¹## Hypothetical Example

Suppose an investor, Sarah, buys shares of a mutual fund over several years:

• Year 1: Buys 100 shares at $10 per share = $1,000
• Year 2: Buys 150 shares at $12 per share = $1,800
• Year 3: Buys 50 shares at $15 per share = $750

Her total investment is $1,000 + $1,800 + $750 = $3,550.
Her total number of shares is 100 + 150 + 50 = 300 shares.

Using the Adjusted Long-Term Average Cost method, her average cost per share is:

Now, suppose Sarah decides to sell 100 shares when the market price is $18 per share.

Her proceeds from the sale are 100 shares * $18/share = $1,800.
Her cost basis for the sold shares, using the Adjusted Long-Term Average Cost, is 100 shares * $11.83/share = $1,183.

Her capital gain on this sale would be $1,800 (proceeds) - $1,183 (cost basis) = $617.
This simplifies tracking compared to identifying which specific securities were sold.

Practical Applications

The Adjusted Long-Term Average Cost method is most commonly applied to mutual funds held in taxable brokerage accounts. Its primary utility lies in simplifying record-keeping for investors, especially those who regularly contribute to their funds or reinvest dividends. Many brokerage firms offer this as a default cost basis method for mutual funds due to its administrative ease.

⁸, ⁹For individuals focused on long-term portfolio management and minimizing accounting complexities, this method can be highly practical. It standardizes the cost of all shares, which can be advantageous if an investor anticipates selling shares acquired at different price points over time. The IRS provides specific guidelines and forms for electing and revoking the average basis method, detailed in Publication 550, which covers investment income and expenses.

⁷## Limitations and Criticisms

While the Adjusted Long-Term Average Cost method offers simplicity, it also has limitations, particularly concerning tax implications. One key criticism is that it may not always be the most tax-efficient strategy. For instance, if an investor sells only a portion of their holdings and some shares were purchased at a significantly higher price (resulting in a loss), using specific identification (selling those high-cost shares) could yield a more favorable tax outcome by generating a larger capital loss to offset gains. The average cost method, by contrast, would spread that higher cost across all shares, potentially reducing the recognizable loss or increasing the gain on the specific shares sold.

Furthermore, once an investor elects to use the average cost method for a particular mutual fund, they are generally required to continue using it for all future sales of that fund across all accounts, unless they explicitly revoke the election. T⁵, ⁶his can limit flexibility in tax-loss harvesting or other strategic sales. While the method simplifies reporting, investors should carefully consider their individual tax situation and investment goals before selecting it. The Bogleheads community, for example, discusses various cost basis methods and their implications, highlighting that while average cost is simple, other methods like specific identification might offer greater tax optimization flexibility.

Adjusted Long-Term Average Cost vs. First-In, First-Out (FIFO)

The Adjusted Long-Term Average Cost and First-In, First-Out (FIFO) are two distinct methods for calculating the cost basis of investments, primarily used for tax reporting. The core difference lies in how they assume shares are sold.

The Adjusted Long-Term Average Cost method calculates a single average price for all shares of a particular mutual fund held. When shares are sold, the gain or loss is determined by comparing the sale price to this calculated average cost per share. This method is often favored for its simplicity, especially when dealing with numerous small purchases and reinvested dividends.

In contrast, the FIFO method assumes that the first shares purchased are the first ones sold. This means that to calculate the gain or loss, you match the shares sold with the earliest purchase lots. If an investor purchased shares at varying prices over time, FIFO might result in higher capital gains if the earliest shares were acquired at a much lower price, as these "older" shares are assumed to be sold first.

⁴The choice between these methods can significantly impact the amount of capital gains or losses reported for tax purposes. While average cost provides a smoothed outcome, FIFO can sometimes be less tax-efficient, particularly in a rising market.

FAQs

Q1: Is the Adjusted Long-Term Average Cost method mandatory for mutual funds?
No, it is not mandatory. While many brokerage firms may set it as a default for mutual funds, investors typically have the option to choose other cost basis methods, such as First-In, First-Out (FIFO) or specific identification.

³Q2: Can I switch from the Adjusted Long-Term Average Cost method to another method?
Yes, generally you can. However, once you elect to use the average cost method for a specific mutual fund, you must use it for all shares of that fund across all your accounts. To switch to a different method, you would typically need to formally revoke your election with your brokerage firm, and there may be specific IRS rules or limitations regarding such changes.

²Q3: How do reinvested dividends affect the Adjusted Long-Term Average Cost?
When dividends are reinvested, they purchase additional shares. The cost of these new shares is added to your total investment cost, and the number of new shares is added to your total share count. This increases both the numerator and the denominator in the average cost calculation, thereby adjusting your overall average cost per share. This is a key reason why the average cost method is popular for investments with automatic dividend reinvestment plans.¹