There’s a portion of the new Senate Tax Bill that is terrible for retail investors, that most might not understand. It has to do with accounting methods applied to the selling of financial instruments.
To start, cost basis is the purchase price for the security. You need to pay gains on your security when you sell it. If the purchase price for your security is different over time, you should always pick the highest price you paid for a security so that you can minimize your gains. If you have less paper gains, you pay less taxes. Your real gains are the same, it’s just an accounting method.
There are many cost basis methods the IRS accepts, but there is only one that I consider to be the worst: FIFO.
FIFO means First-In-First-Out, and for the average retail investor who buys a security and holds it for a long time, you definitely don’t want this type of cost basis method determining your tax bill. Considering the market goes up over the long-term, you never want this type of cost basis. You always want to choose the highest cost basis to minimize your taxes on your profits. If you choose the highest cost basis and it’s higher than the price you sold it for, this is tax harvesting and you can net $3,000 of losses against realized gains in a year. Otherwise the losses roll over to net against next year’s gains.
The best cost basis method is Specific Identification as it allows you to have the lowest cost basis. This leads to the minimum you could pay in taxes. If you can chose the cost basis as the highest price you ever paid for a security when you sell it, this would allow you to minimize your taxes each time you sell.
A lot of mutual funds/investment firms use average cost, because it’s easier on their systems, but you can choose “SpecID” and manually sell the lots with the highest price. Vanguard has this choice, and so do many other funds.
Why do you want to use Spec ID and never use FIFO? Let’s say you’re an average retail investor who decided to buy VTSAX (Vanguard Total Stock Market, very low expenses). You bought 500 shares at $18 a share. Over the next few years you decide to buy 500 shares each time at $35, $16, $50, $57 and finally $66. You buy your shares in this order of prices (this is important!). It’s currently $66 a share.
You now own 3,000 shares. Let’s say your grandma got cancer and cannot afford the radiation treatment deductible. You want to help her out and decide to sell off some of your VTSAX. Your grandma needs $5000, so you decide to sell 76 shares of VTSAX.
Under Specific Identification: $0 in tax because you pick your cost basis to be $66, as you bought the last 500 shares in your account at $66.
Under FIFO: You just made $3648 in paper profit, so you’ll have to pay taxes on that. Under FIFO, your cost basis is $18, because those are the first VTSAX you bought. Depending on if you have held your assets for a year, you’ll have to pay a different tax rate.
Average Cost:You just made $1951 in paper profit! The average cost per share of your portfolio is $40.33. Depending on if you have held your assets for a year, you’ll have to pay a different tax rate.
The money you actually realized is the same, but if you choose a different cost basis, you pay different taxes.
Currently the bill exempts investment companies from this rule, but it would harm the retail (and you! The FI/RE community) sector if you have your assets in non-RICs.
A RIC (Regulated Investment Company) can be one of three kinds: Mutual fund or ETF, REIT, or UIT.
Vanguard will still be allowed to use SpecID if this bill passes, as it is a RIC and houses mutual funds and etfs. If your money is in other ETFs, Mutual funds, REITs, or UITs, and is in a RIC you would still be allowed to use SpecID as well. If you have single-name stocks, options, or other derivatives, you’d need to use FIFO.
If you have your money in a robo-advisor, they would have to use FIFO, and their tax loss harvesting algo wouldn’t be able to efficiently harvest losses for you, as they are not a RIC. They are regulated financial advisors who put your assets in funds that are created by other RICs. A good rule of thumb to understand if a company is a RIC or an advisor is to see if the company’s name is on any of the assets or if the company has a specific line of funds. Own VTSAX? It’s a Vanguard fund, so RIC. iShares S&P 500 Index Fund? RIC, because iShares are all BlackRock funds.
Solutions if your money is not in a RIC?
1). Put it in a RIC. Vanguard funds have the lowest expense ratios in the industry.
2). If it’s a non-RIC security, ie. stocks/options/derivative, house different cost basis across different brokerages if you are doing this in large amounts. Only do this if you think it’s more cost-efficient than paying the fees to trade stocks at different brokerages instead of buying them all in one brokerage.
I’m not sure what would happen in the case for bitcoin and currency. If anyone is familiar with that, please let me know.
One thing to note, is that once you pick a cost basis, the IRS will flag you if you switch it to another. Pick one (Specific ID!), and stick with it, unless something materially changes.
If this bill doesn’t pass, you’ll still have learned something. When you do your taxes, are you or your investment firm using the FIFO, average cost, or specific identification method? If it’s not the specific ID method, you need to that fixed before April, or at least by the next time you decide to sell some securities!
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